The doves remain in charge

In financial language we distinguish between “hawks” and “doves” regarding the orientation of central banks' monetary policy. The former tends to adopt a “tougher” stance on interest rates, while the latter tend to pursue a “softer” approach. Federal Reserve Chairman Jerome Powell clearly belongs to the doves, and this camp seems still firmly in control after this year's Jackson Hole central bank symposium. Powell’s core message to the financial markets made it clear: while the economy has made encouraging progress, the development of the corona pandemic continues to create a high degree of uncertainty. This means that the Fed will adjust its monetary stance in due course, but tapering, or in other words, a reduction in quantitative easing (QE) does not seem imminent – for sure not at the next FOMC meeting on September 22. Although the Fed could start tapering, i.e. reducing securities purchases, before the end of this year, a first interest rate hike is not expected for quite some time – probably not until 2023 at the earliest. This guarantees a continued positive environment for companies and the stock markets.

On capital markets, an initial increase in the Fed’s key rates is still not expected for another 18 months (graph 1). This expectation has already held steady for two quarters, implying that the start of the US interest rate cycle is being pushed continuously into the future. Consequently, financing conditions remain cheap, and it is therefore hardly surprising that investors reacted calmly to Powell's statements at the Jackson Hole conference. Stock indices on Wall Street even managed to climb to new alltime highs, while long interest rates fell slightly. 

Growth and inflation mix continues to provide tailwind

From an economic perspective, the growth and inflation mix should remain positive. While we can observe that the leading indicators in the US (purchasing managers' indices in manufacturing and the services sector) have already passed their highs for the time being, while the PMIs continue to signal an expansionary course and GDP growth above potential. The eurozone economy appears to be entering a similar phase, as the German Ifo business climate index has apparently lost momentum. At the same time, inflationary pressures increased on both sides of the Atlantic and are trading above the long-term average of the last 20 years. For the moment, however, it looks as if inflation will not accelerate further. The big question remains: is excess inflation only a temporary phenomenon, or will base inflation increase in the next few years?

High leverage poses a challenge

Should the Fed begin tapering in the foreseeable future, the question of the degree of leverage on stock markets will inevitably arise. As graph 2 impressively illustrates, a continuous rise to unprecedented highs has been observed in recent years. High leverage is per se not worrisome, but it can become problematic if market players are unable to service it due to rising volatility, or if there is insufficient liquidity in the overall market. Given the current leverage, we expect that if volatility rises quickly, the leverage is likely to exacerbate market volatility. 

Investment strategy: Improve quality

As we enter the final third of this year, we recommend increasing the quality in the portfolio across all asset classes. We continue to believe that in the current macroeconomic environment, private investors should tend to maintain a “risk-on bias” in their portfolio. However, “truffles” are becoming scarcer in all asset classes given the current valuation levels. We recommend continuing to focus on the quality portion of the allocation. Seasonality – September to mid-October – is likely to bring increased volatility on stock markets. In our view, in the current setup, potential setbacks remain buying opportunities.

At the asset allocation level, our two key convictions remain unchanged. We prefer equity investments to bonds and expect commodities to yield a better return than liquidity. The equity risk premium compensates relatively better than bonds, even after the recent rally, although the absolute valuation would justify higher volatility in equities at any time. Selection will be key to alpha generation through the end of the year.

Global earnings growth has probably peaked in the summer of 2021. However, this is not negative per se, as we mainly have to pay tribute to the base effect as well as the relative rate of change – the same as with the leading economic indicators. The current macroeconomic environment remains positive for the rest of the year, but the wheat is increasingly being separated from the chaff. For us, the focus is on sales growth, stable margins and thus a guarantee for earnings growth. We continue to favor Europe, and at sector level prefer consumer staples and utilities. So, the spotlight will be on quality, and the time for experimentation is not advisable at current valuation levels and monetary policy direction. 

Corporate bonds replace high-yield bonds

In fixed income, we expect steady upward pressure at the long end of the yield curve in the G7 countries. Nevertheless, we do not expect the ten-year US government bond yield to trend toward 2% in the current environment. The interest rate environment remains low and thus investment opportunities for private clients are also limited. Our favorites remain emerging market bonds in local currencies and hybrid bonds. However, we are adjusting our rating on corporate bonds from “unattractive” to “neutral.” At the same time, we are downgrading high yield bonds, from “neutral” to “unattractive.” With this rating adjustment, we are also increasing our quality ratio. On the equity side, we would invest the risk budget freed up by the sale in the sectors consumer goods or utilities.