Flax: Things to think about as we head into Q4

As we head into the fourth quarter of the year, we wanted to highlight some of the key issues that the Asset Allocation team has been focused on.

The first is duration – more specifically should we be buying longer-dated government bonds? We see some pros and cons. On the positive side, bonds look better value than they did. Bond yields have risen and there are signs that inflation is decelerating and the global economy is slowing. We think that Central banks are close to a peak in terms of hiking policy rates and could bring down rates in 2024. On the negative side, inflation is still some way above the 2% target that Central banks have typically followed and it’ll probably be tough to get there. There are still some inflationary pressures in developed economies – labour markets are tight and the oil price has been rising – and in places like the US, the economy has actually held up pretty well, despite higher rates. That suggests policy rates could stay higher for longer.

The other consideration is that in many countries longer-dated bonds are yielding less than shorter-dated bonds – a so-called inverted yield curve. Normally, you’d expect the reverse. So, if you think policy rates will stay high and inflation could be stubborn, then buying longer-dated bonds could be premature.

A second topic of conversation has been around equities and equity valuations. Overall equities have performed relatively well so far this year, but the performance has been quite concentrated in a relatively small number of names. On a regional basis, we’ve seen a steady re-rating of US equities relative to other markets. There are some good reasons for this – in aggregate US stocks have historically shown faster growth and higher profitability. In theory that should merit some sort of premium. That’s partly a reflection of the sector composition, with more exposure in the US to large technology companies.

The economic environment in the US has also held up better than in Europe so far this year, and that should also be reflected in the performance of US-focused businesses. One challenge for arguing to sell US equities and buy non-US equities is that it has been a reasonable argument for a number of years and historically has not really worked. Could this time be different?

A third topic has been around commodities, specifically the rising oil price. Rising commodity prices typically provide winners and losers. We’ve already seen increased interest in energy stocks for instance over the past few weeks. At the same time, rising oil prices can feed into inflation and we would expect to see that reflected in some countries in the coming months, even as we see slower growth in developed economies. That could present an additional challenge for Central Banks and households as we approach winter.

Finally, there is a wide array of other issues to consider – particularly on geopolitics, domestic politics and global issues such as climate change. As investors we need to address several questions – not just how these issues might develop, but when, and if, they could become relevant for financial markets.

In recent years, we’ve noticed how financial market participants have collectively seemed to ignore geopolitical issues for long periods of time – even as they have potentially become more significant. That has the potential to cause periodic spikes in market volatility, and it’s something we consider carefully when we think about how best to construct our model portfolios.