Spring is finally here, and it looks like the weather is gradually improving. We got so used to the gloom of March and April that it’s perhaps natural to extrapolate the same conditions for May. But the sunshine came unexpectedly. Put differently, in investment jargon, relative to our downbeat expectations, we got a surprise to the upside.
Something similar is beginning to happen to the Eurozone (and the UK). It showed signs of recovery in the first quarter of this year, as the economy came out of the mild recession it experienced in the second half of last year. It grew above expectations and at the fastest rate since the third quarter of 2022. As inflation continues to soften, we expect the European Central Bank (ECB) to start cutting interest rates in June, before the US Federal Reserve (Fed).
As the outlook for Europe is getting better, a trend we believe is underappreciated in the marketplace, I and the Investment Committee have decided to shift the mix of assets we hold in the region. When the outlook improves, the course of action is to raise equity exposure and reduce bond exposure, which is what we’ve done this month.
Over the past three months, we’ve owned more European investment grade bonds relative to our long-term asset allocation. We still believe they are high-quality corporate bonds, but the price of these bonds has increased (and the yield, which has an inverse relationship with the price, has decreased). This increase in price reflects market expectations of better economic growth and ECB interest rate reductions at around mid-year.
The key valuation measure for corporate bonds is the ‘spread’. In simple terms, this is the difference in yield between corporate and risk-free bonds. When the spread tightens, it means that corporate bonds are performing well. When it tightens below the long-term average, it’s a signal that valuations are perhaps becoming relatively more expensive. That’s where we are now, so we’ve reduced our exposure.
The European economy seems to have picked up momentum. And it’s not just the headline figures on Gross Domestic Product (GDP). If it were only that, one would want to take any improvement with a pinch of salt. This is because concepts such as GDP, while useful, are like looking at the economy via the rearview mirror. More timely and forward-looking indicators, such as the Purchasing Managers’ Indices (PMIs) and consumer confidence, show that the Eurozone economy is on a recovery path. Add to that the prospect of interest rate cuts from June now that inflation has slowed to 2.4% (very close to the ECB 2% target), and we believe this recovery might well continue.
Think of our switch from European bonds to equities as a continuation of what we did last month, when we shifted our minimum-volatility European equities into the broader European market. The logic was that, in Europe, growth was still weak but no longer getting worse. Rather, it appeared to have bottomed out. Therefore, we thought it was unlikely that European minimum-volatility sectors (which do comparatively well when the economy is worsening) would outperform the broader European market. This is the same concept. We think it’s unlikely that European equities (ex UK) will underperform global equities, and so we’re adding to this market, where valuations are attractive.
You may already be aware that we recently launched the first two in a series of multi-manager funds, known as our QMM fund range, which we’ve co-created with BlackRock. In April, we launched the QMM Actively Managed US Equity Fund and the QMM Actively Managed Global High Yield Bond Fund.
QMM, which blends leading third-party managers with the aim of outperforming the benchmark by combining different styles of actively managed strategies, is available to all Quintet clients, from those who invest in our flagship portfolios to those in customised and advisory portfolios.
Last week, we launched our third QMM fund: the Actively Managed Continental European Equity Fund. This month’s investment into European equities ex UK has been implemented through this new fund.
In our previous Counterpoint, I spoke about how we’d brought our equity and bond allocations “back to neutral” at the start of 2024. As a reminder, this simply means that our short-term allocation aligns with our long-term allocation – at least for equities and bonds. Our sale of European investment grade bonds and purchase of European equities ex UK means that, technically, we now own very slightly more equities compared to our long-term allocation. But it’s important to put this in context.
While the outlook for Europe (and more broadly) appears to be improving, one doesn’t want to be complacent. We’re not making this trade because we believe European equities are going to take off. In fact, we still have a slightly reduced exposure to European equities, just less than before. Similarly, we still own more European investment grade bonds relative to our long-term allocation, just less than before. And we still think this asset class is compelling from a medium-term perspective, so continuing to earn a good rate of interest seems like the right thing to do.
Our aim is to protect and grow our clients’ wealth. So, we think it’s good practice to move step by step and validate our assumptions on markets, the economy and companies. We want to see whether the European recovery we envisage, and begin to see in the data, really takes hold more firmly.
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