European recession fears resurface

• Last week, the main headline was the downgrade of the US long-term rating to AA+ from AAA by Fitch Ratings, sending 10-year US Treasury yields temporarily to their highest levels in 2023, at some point reaching close to 4.2%. Yet it was actually European equities that underperformed the most due to concerns that economic and earnings growth may slow more than expected, potentially leading to an outright recession.
  
  
• We do not think Fitch Ratings’ downgrade poses a major threat to the markets, with the US dollar status as the world’s reserve currency and the ability of the US to service its debt remaining strong.
  
  
• Europe equities, however, remain an area of concern to us: they fell further than the US last week, in part driven by increased expectations of a slowdown of economic activity in Europe, particularly driven by a weaker manufacturing sector – which is already in recession.
  
  
• Our view remains that the corporate earnings outlook in Europe could deteriorate, and we take comfort that our investment in European low-volatility stocks can benefit in such a scenario, as was the case last week.
  
  

• With the above developments, we are seeing increased evidence that a prudent market stance is warranted. Macroeconomic uncertainty for the year ahead remains elevated, in our view, given the potentially negative impact from higher interest rates on economic and earnings growth. The longer interest rates stay elevated, the higher the probability of negative surprises for economies and markets.
  
  
• As a result, our flagship portfolios continue to maintain a quality bias, a slightly lower than normal equity exposure and a higher-than-normal exposure to high-quality government bonds.
  
  
• We think the case for high-quality bonds remains rather compelling. We anticipate central banks to eventually halt the tightening of monetary policy. Even though the Bank of England (BoE) did raise rates by 25 bps to 5.25% last week, as expected, and may have more to do than other central banks, the US Federal Reserve (Fed) and the European Central Bank (ECB) seem close or at the point of pausing altogether.
  
  
• Given the deteriorating economic backdrop, they may even contemplate cutting rates next year, though we think this is more likely to happen sooner and/or to a greater extent for the Fed and the ECB than the BoE, given that inflation in the US and the Eurozone seems less stickly than in the UK. This view is supported by recent leading indicators such as the deterioration of the purchasing managers’ indices in Europe or the Conference Board Leading Indicator for the US. Job growth in the US, last week, did surprise to the downside.

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