Schroders multi-asset investment team remains positive on equities, but the disruption to energy supplies caused by the Middle East conflict may persist longer than originally thought, says Patrick Brenner, Chief Investment Officer, Multi-Asset, Schroders.
We were correct to maintain our overweight position in equities through the geopolitical uncertainty of recent weeks, but we need to acknowledge that the disruption to energy supplies is likely to be more persistent than was originally thought when the conflict in the Middle East began. At the same time, corporate earnings have proved to be resilient and, when we model the impact of higher energy prices, there is significant regional divergence, with the US being relatively unaffected while Europe and Asia are more vulnerable.
Last month, Schroders’ multi-asset team took profits on its broad commodity exposure when energy prices spiked. The situation in the oil market continues to be highly binary and driven by geopolitical events. It is therefore very difficult for us to take a view at this level of prices. Recognising the risk of more protracted disruption, we decided to establish a long position in agricultural commodities, where prices have not responded so far, seasonal weather effects support demand / supply dynamics, and higher energy and fertiliser prices would have a lagged effect. We reiterated our long position in gold; although we acknowledge that its correlation to equities has increased, we continue to believe that it offers a better defensive exposure than government bonds given our concerns about long term debt sustainability.
After the rapid repricing in rate expectations, bond valuations based on our fair value model are no longer expensive, removing a key driver behind our negative stance on government bonds over the past six months. At the same time, the macro risk distribution has evolved. Whereas previously our risk scenarios were heavily skewed towards inflation with virtually no risk of recession, we now see a more balanced trade-off between inflation and growth. Against this backdrop, we have closed our short government bond position. Within regions, we maintain our underweight position in US bonds, where the economy remains relatively more resilient, but upgrade European bonds, specifically BTPs, where we view current rate hike expectations as overly aggressive. We believe the carry cushion is large enough to help absorb ongoing volatility, particularly as macro risks are now more balanced than before. We remain underweight investment grade bonds in the US as current spreads offer little protection against the potential stagflationary risks and increasing issue.
Equity valuations have improved slightly as prices have not kept up with earnings. Given uncertainties related to geopolitical and technological disruption, we think this de-rating is appropriate but expect further gains from equities driven by earnings. We continue to have bias towards the US and technology as earnings trends are most supportive here. In order to diversify our risk, this month we also add to UK and Canadian equities given their higher exposure to the energy sector.
We downgrade the US dollar from positive to negative, reflecting the relative dovishness of the Federal Reserve (Fed). We remain positive on local emerging market debt and have upgraded the yen.
All in all, our central scenario is still one of positive nominal growth, supported by government spending and strategic investment in defence and the resilience of supply chains. This leads us to still favour equities although we have reflected the increased risks posed to growth from disruption in the Middle East by neutralising our underweight position in government bonds and going long agricultural commodities and energy-related equity markets.
A detailed overview of Schroders' positioning across different asset classes can be found here.
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