Markets paused in August following the strong rally seen in the first seven months of 2023. The MSCI World index lost 2.6% in August but nonetheless ended the month 14.9% higher than at the end of last year. The equity market sell-off occurred as long bond yields rose, with the US 10-year Treasury yields climbing above 4.3% for the first time since 2007. The increase in US bond yields relative to European yields supported the US dollar which also benefited from increased investor risk aversion.
The global economic outlook remains mixed. US GDP growth has performed better than expected although eurozone growth disappointed, negatively affected by the weakness in global trade and the Chinese economy. The latter continued to lose momentum, burdened by the ailing real estate market and the lack of stimulus from either monetary or fiscal policy. Lacklustre GDP growth in China is the most relevant downside risk to the global economy.
The overall moderation in global growth was to be expected after the unprecedented monetary tightening implemented since mid-2022. Equally unsurprising is that inflation, while still higher than desirable, is now falling in most countries, at least at the headline level. Financial markets will benefit from this inasmuch as it allows central banks to take time to assess the need for further tightening.
The implications for the asset allocation of a diversified portfolio are that a slight overweight in both equities and bonds is warranted at the expense of liquidity and alternative assets.
Within equities, the increasingly uncertain outlook for China justifies a reduction of exposure to emerging Asian equities and a reallocation of capital to US and eurozone markets. The valuation of European equities warrants an overweight exposure while the US market is underpinned by a solid macroeconomic outlook and improved earnings.
Among fixed income assets, the tightening of US dollar denominated high yield bond spreads seems excessive compared to the deterioration in the global business cycle. Reducing exposure in favour of sovereign bonds is advisable also to contain the overall riskiness of the portfolio.
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