The market has traded many different macroeconomic narratives in the last 12 months. From a near unanimous belief that a US recession was coming, the view has shifted to a conviction that a soft landing is possible, despite a record pace of monetary tightening.
Of course, focusing only on monetary policy is very ‘pre-covid’; fiscal policy has become increasingly important. It has sustained growth in recent quarters, but has also led to higher bond yields amid mounting concerns in markets about high deficit spending and debt sustainability.
Growth – We expect some softening in 4Q
Desynchronisation continues to be a feature of the post-covid period. In the third quarter of 2023, global growth momentum was buffeted by weakness in China and the EU, but supported by strength in the US.
While policy in China is becoming more supportive, the measures taken so far have not been sufficient to change the trajectory of growth there. Europe remains in the slow lane.
In the US, various elements of the economy have been moving in different directions. Housing, the most interest-rate-sensitive part of the economy, had a difficult 2022, but bottomed at the start of 2023. The recovery was dominated by new home sales, however, while existing home sales remained weak. Recent housing data has been disappointing relative to consensus expectations and the sector has started to underperform the broad equity market.
In contrast, manufacturing looks to be improving. The gap between new orders and inventories has narrowed as inventories have fallen. It is possible that firms over-ordered in 2022 with China still locked down. Now that those inventories have been worked off, the outlook for production should improve. The latest manufacturing ISM appears to support this view. Some industrials have also been supported by the secular trend of companies re-shoring production back to the US, and by the US Inflation Reduction Act (IRA) subsidising green investment.
Over the last several quarters, earnings growth has surprised positively, but we doubt this can be sustained. There may be pockets of strength in artificial intelligence (AI)-related sectors, which would support profits for some of the mega-cap tech companies. Much of the rest of the market, however, has been buoyed by the ‘money illusion’, that is, in a period of high inflation, nominal profits rise as companies raise prices, but underlying volume growth is lacklustre. As inflation abates, profitability may come under strain.
Growth and inflation
The strength of the labour market has been the key pillar of the macro narrative. We expect this to fade away into year-end; a leading indicator of the labour market suggests the unemployment rate will rise (see Exhibit 1). The latest, well-above-expectations, private non-farms payroll data for September might seem to point in the opposite direction.
Aside from wageinflation, consumer price inflation has slowed materially in recent months, boosting real disposable incomes. That tailwind could be fading, though, especially as commodity prices appear to be on a renewed uptrend.
The medium-term outlook for inflation is more uncertain. The global economy has changed in a material way since Covid. Supply chains are being rebuilt to improve domestic resilience to external shocks. Governments are providing large subsidies to drive the energy transition. Labour is gaining at the expense of capital as wages rise. All three of these are fundamentally inflationary and add to an already large fiscal burden.
Policy tightening – Impacts not fully felt
The transition from Goldilocks to a potentially stagflationary environment poses a challenge for the US Federal Reserve. For now, nominal growth remains strong, but given our concerns over the housing and labour markets, this may not persist. The tone of the September policy meeting was hawkish, prompting the market to price out rate cuts expected in 2024.
Higher for longer rates should slow the economy. Good nominal GDP growth has helped contain corporate credit spreads, but issuers face a large maturity wall in 2024 and 2025 when they will have to refinance at much higher rates, eating into profits.
To an extent, central banks risk losing control of interest rate policy with bond markets selling off globally, partly driven by concerns over debt sustainability. Recent Fed comments have expressed some concern over the tightening in financial conditions, leading to calmer bond markets.
In our view, there is a limit to the recent sell-off in fixed income. We think bonds look attractive, especially if we are correct in believing that rates have peaked, and growth starts to weaken.
Déjà sort of vu
The increase in US Treasury (and subsequently global) yields has been an (unpleasant) reminder of what occurred in 2022, that is, rising real yields leading to a compression of (growth) equity multiples.
The sell-off began in August with Fitch’s downgrade of the US long-term debt rating and resumed at the latest Fed meeting when in their ‘dot plot’, policymakers laid out their forecasts for the level of the fed funds rate in the years ahead. This showed a bigger increase than the markets had expected for 2024. Technical factors such as positioning and overseas sellers have also likely contributed to the rapid rise in Treasury yields.
While the reasons for the sell-off in interest rates are debatable, the impact on equity markets is not. Equity indices have declined globally. The impact on earnings will likely be seen in the weeks and months ahead.
At the same, the impact has been far less dramatic and, in some ways, quite different to 2022. Then, 10-year Treasury yields rose by 270 bp and the Russell 1000 Growth Index underperformed the Russell 1000 Value index by 14 percentage points (growth -28%, value -14%).
Since 31 July this year, yields have increased by a further 65bp, but growth has outperformed by 4 percentage points (growth -3%, value -7%; see Exhibit 2).
Valuations have changed as they did in 2022, but earnings expectations have been different. The forward price-earnings ratio of the Russell 1000 Growth index has fallen from 27x at the end of July to 24x today, a decline by 9%. The decline in the index, however, has only been 3% because earnings estimates have risen by 6%, partly driven by enthusiasm around AI. In 2022, by contrast, earnings expectations for value stocks outpaced those for growth stocks (see Exhibit 3).
Regional equity markets
Several factors argue for an overweight position in Japanese equities: positive earnings trends, supportive central bank policy, and neutral equity valuations. We have nonetheless held back chiefly because of the weakening yen, which has fallen to its lowest level in 11 months.
Equally, UK equities arguably look attractive thanks to low valuations. The FTSE 100 is not really influenced by domestic considerations, with over 70% of revenues generated overseas. We find its low beta characteristics attractive (high dividend yields and a sizeable weight in healthcare and consumer staples). We have used recent market weakness to build a position.
Our long-term valuation framework suggests US and European equities are overvalued. The demanding US valuations are sufficient to hold us back from turning positive, but we have taken advantage of recent softness to neutralise our modest remaining underweight position.
Relative to developed markets, emerging market stocks have been trading at a considerable discount. Within emerging markets, the focus has remained on China.
Our macro team is relatively positive on the outlook. They assume that policymakers have the firepower to address the current weaknesses in the economy, including in the housing market and the trust sector. Further stimulus from the central government is seen as inevitable, even as China’s tolerance for economic pain has clearly increased. Geopolitical tensions, in particular with the US, remain a concern given that ‘getting tough’ on China is one of the few areas with bipartisan support as next year’s US election approaches.
As for asset allocation, multi-asset portfolios remain exposed to China through both a positive tilt on emerging Asian equities, where China accounts for around a third of the index, and via long positions in emerging market local debt. Positions are, however, lower than they have been for several months. We have been using recent weakness in developed markets to reduce the risk of relative value equity regional positions.
Commodities were lowered to neutral as we reached our targets.
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