- Central bank policy rates are priced to reach 5.0-5.5% in the US and 2.75% in Europe by mid-2023. Forward real rates are at post GFC highs in both regions, approaching the ‘old normal’ of the 2000-2009 period. Given that the downside risks to both growth and inflation are mounting, we believe the interest rate backdrop is increasingly restrictive and the need for policymaking to ‘pivot’ forward is clear.
- We have deepened our long position in European investment-grade credit, without increasing our fixed income duration hedge in tandem, thereby taking a more positive stance on duration.
- We have taken a small long position in US equities, in particular US technology stocks where valuations are looking increasingly attractive. Tech stocks can be seen as more defensive by nature and they should be an important beneficiary of the expected ‘pivot’; seasonality is favourable too for this tactical position.
- This US equity position has replaced our long-standing preference for Japanese equities. Japan has smartly outperformed Europe ex UK (our main short) this year, but the outlook is darkening and Japanese companies are operationally highly levered to the global cycle. Given increasingly challenged policymaking and fuller relative valuations, the supports for our position weakened considerably.
Underscoring the still heightened market volatility, fixed income premia moved notably higher over October, led by real yields. Many in the market, including leading central banks, focus on 5-year/5-year forward real yields as a long-term indicator of the ‘neutral’ level of policy rates.
This year, these rates have risen from the lows of the last 50 years  to levels last seen before the Great Financial Crisis (GFC). Effective policy rates have also risen significantly.
According to market pricing, policy rates should reach 5.0-5.5% in the US and 2.75% in Europe by mid-2023. At those levels, these rates are not neutral, rather they are restrictive. In other words, economic growth is squeezed at such levels.
The spike in expected rates comes just as the effects of central bank measures taken so far are feeding through to the economy in the form of weaker growth and inflation; the tough policy tightening is starting to bite.
Overall, we remain neutral on government bonds, but have increased our overweight positions in European investment-grade credit.
It is earnings season
Investors have eagerly awaited third-quarter earnings reports to see if concerns over cascading profit warnings would materialise. Declines in US equities this year have been driven more by rising real yields/discount rates than falling earnings expectations, while in Europe, worries over growth have predominated.
While we believe there is room for earnings expectations to fall in Europe, they have already fallen a long way in the US, especially for tech names.
The S&P 500 was forecast to generate only 1.5% earnings growth this quarter versus Q3 2021, and 75% of the increase was due solely to the energy sector. Excluding energy, earnings-per-share (EPS) was expected to drop by 6%. Europe was forecast to see 20% earnings growth at the index level, but just 5% ex-commodities.
With that backdrop, the fact that US earnings growth ex-commodities so far has been negative is not surprising to us (see Exhibit 2). Most sectors have nonetheless beaten the analysts’ estimates, with the notable exception of the interactive media industry, where several large companies have disappointed. Europe has beaten the US again (as it did in the last quarter).
As always, though, it’s the future that matters more to equity investors. A key driver of the recent bounce in US markets has been better-than-average guidance from companies on the outlook when investor sentiment towards equities was extremely poor.
Though there have been notable profit warnings in recent weeks, many were in industries that had benefited from the lockdowns, but were now seeing earnings revert to pre-pandemic trends. Across the index, however, the guidance has been in line with that of the last quarter and above the long-run average rate of just 23% (see Exhibit 3).
Aside from earnings expectations, the main negative factor for equity markets has been real interest rates. This should be less of a risk for equity markets from here on. Eventually, it should turn into a positive factor once the Fed pivots to lowering policy rates.
The impact of higher policy/discount rates has been most keenly felt in multiples of long-earnings-duration growth stocks. When real yields plummeted during the lockdowns as the Fed embarked on its biggest round yet of quantitative easing, valuations soared to levels not seen since the tech bubble era of the late 1990s.
That policy accommodation is being painfully reversed now. Five-year five-year real yields have risen by nearly 200 bp this year. The good news is that real yields and growth stock valuations have largely normalised (or at least normalised for the post-Global Financial Crisis era).
As a result, the NASDAQ now looks to be one of the more attractively priced markets (see Exhibit 4). Accordingly, we have rotated our Japanese equity market exposure towards US equities, in particular, tech stocks.
Japanese equities had significantly outperformed Europe ex UK this year, but the economic outlook is now darkening and Japanese companies are operationally highly levered to the global cycle.
Given the increasingly challenged policymaking and fuller relative valuations, the supports for our long Japanese equity position have weakened considerably. Notwithstanding decent corporate fundamentals, we have now cut Japanese equities to neutral, with both valuation and fundamental support.
With fed funds rate expectations having peaked, valuations of US growth stocks should now be driven primarily by earnings. As mentioned, these soared during the lockdowns and the trend versus value earnings has been reverting since, particularly amid higher commodity prices and financial sector profits (see Exhibit 5). As the US economy moves closer to recession, though, the superior earnings growth from the growth style should result in relatively greater performance.
Commodities and currencies
Commodities has been one of the few asset classes to deliver positive returns in 2022, although they have now fallen into bear market territory from the peak earlier in the year.  The asset class remains in our ‘favour’ bucket.
The five key supports for this position are all in place, recession concerns notwithstanding. They include:
- Strategic developments such as the sustainable (energy) transition that are commodity-intensive
- Geopolitics, where commodities are arguably one of the few beneficiaries (for example, from resource nationalism)
- Scarce supply
- Asset allocation/diversification benefits
- The Chinese economy reopening, constraining base metal supplies.
Precious metals, especially gold, may be an attractive inflation hedge, albeit intimately linked to movements in real rates and the US dollar.
Currencies matter for commodity returns. Monetary policy and interest rate differentials have driven exchange rates this year, favouring the US dollar in both real and nominal terms. Recently, these relationships have been challenged, and it is now currency moves driving real rate differentials rather than the other way around.  All in, we are neutral on currencies.
 From -85bp in the US and -1.4% in Europe around this time in 2021 to 1.25% and 1.50% in Europe and the US, respectively
 The BCOM index has fallen by 30% from its peak. A bear market occurs when the index falls by more than 20%
 Granger causality test on EUR/USD and the 2-year nominal and real interest rates differential