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Navigating Uncertain Markets With a Defensive Approach

June 5, 2023 6 min 11 sec
Éric Morin,
CIBC Asset Management
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Eric Morin, senior and analyst at CIBC Asset Management.

So first of all, uncertainty is elevated, but our central outlook remains a hard landing. What is more uncertain is the timing. So just a little bit of context, underlying growth has been resilient reflecting the shortage of workers and housing, but both the shortages also mean more limited downside on core inflation. And this is important, because sticky inflation reinforces the need for policy rates to remain in restrictive zones for longer, which increases the likelihood of hard landing. So the big picture implication on our side is that we have an asset allocation that is more defensive. So what we like is our government bonds and cash also.

So for government bonds, we expect bond yields to move lower, as decelerating growth gets recognized more broadly by markets, which would mean higher bond prices. And for cash, with the inverted yield curves, it offers a decent carry. It has virtually no valuation risk, and also offers the flexibility to redeploy risk if needed. So it doesn’t happen often that you get paid to move on the sidelines.

What we dislike are equities and credit spread. This is reflected in our portfolios. We expect equities to get repriced lower and credit spreads to widen materially. For equities, the region that we dislike the most is the U.S. stocks, they are more overvalued than elsewhere. So we consider that they have more cyclical downside. The region that we like is, in general, emerging market for government debt or government bonds. So their currencies are currently undervalued and carry is also appealing. So emerging market is what we like for government bonds. We do like India, Indonesia, so Asia is the region that we prefer.

For fixed income, we prefer government bonds in general in both developed markets and in emerging markets, because of duration. So we consider that prospects for yield are on the downside, which is positive for valuation. And regarding the U.S. dollar our view for the U.S. dollar is that it may faces more upside in the near term, given its safe even properties. However, the U.S. dollar is extremely expensive by historical standard and across countries. So it’s a currency that we consider that has limited upside. And the mirror image of an expensive U.S. dollar is that some currencies are extremely cheap and this is the case for several emerging markets. And so this increase the attractiveness of government bonds in emerging markets.

For gold, it’s an asset that we like in our portfolio, because one of the attractive properties of gold is that it could provide a hedge against idiosyncratic risk, and there are many of them. So there are fiscal risk, monetary policy mistake risk and also some geopolitical tensions that could make gold an outperforming assets, so it’s something that we like in our portfolio as a hedge.

So we think the global outlook faces more important downside risk that are underappreciated by markets. U.S. monetary policy is in a restrictive zone. It should start to have more visible negative impact on growth. So this is negative for the U.S. economy. We have already seen signs of slowdown in retail sales, in manufacturing activity as well globally. So we think that those cyclical sectors will contribute to a slowdown of growth in the U.S.

Where perhaps the growth slowdown is likely to be more or could be more pronounced or visible is in China. In China, we don’t believe that the consumer is strong enough to lead a self-sustaining and organic recovery. We think that there is more weakness to come from China. However, on the positive side is that this will force policymakers to launch new rounds of stimulus in the second half of the year. So China is likely to be an increasing source of concern for the global economy. However, China is a place where policymakers can have some leeway to implement counter cyclical policies, which is not the case in the U.S.

So to sum things up, more weakness for growth. This is our base case. We see more signs of this in the U.S., as well as in China. The biggest problem is that inflation has remained sticky and should remain sticky given the shortage of workers. So there’s not enough workers given the shortage of housing, so there is not enough housing from a stock perspective.

So both shortages should continue to keep trend inflation somewhat elevated. And this is important, because for the U.S., for Fed, it reduces the downside on the policy rate. So it reduces the magnitude of cuts that they could implement in the event of a recession, in our opinion.