Economic growth and inflation are slowing, developed country central banks are nearing the end of their tightening cycles, and some emerging market central banks have begun easing. This should lead to lower bond yields and better returns than for equities.
Global equities fell by 3.0% (MSCI AC World in US dollar terms) from the end of July to 9 August, while the yield on the US 10-year T-note rose by 12bp (to 4.08% on 9 August). The previous week it had stood at 4.18%, the highest since early November 2022.
The increase in US Treasury yields was driven by several factors: Fitch’s US sovereign rating downgrade on 2 August, a heavy bond issuance programme, upward pressure on Japanese government bond yields since the Bank of Japan’s yield curve control policy tweak on 28 July, and the resilience of economic indicators in the US. We believe this increase, however, will not be sustained.
Expectations for near-term US monetary policy have nonetheless been stable over the last month. Markets have held steady in their view of the federal funds target rate, foreseeing it in the 5.25%-5.50% range at the next Federal Open Market Committee meeting on 20 September, and at just over 4.00% at the end of 2024.
Investors are still looking for clarification on the timing and pace of easing in 2024. For the time being, Chair Jerome Powell has refused to get into a discussion about exactly what rate of inflation would trigger rate cuts next year. The annual central banker symposium at Jackson Hole, Wyoming, on 24/26 August may be when Powell gets more specific.
Less solid indicators than you might think
The latest US job report was slightly below expectations, showing 187,000 net jobs created in July compared to the forecast 200,000. This was the second consecutive month of job creation below 200,000 after the downward revision of the previous months (-49,000 over May and June). The decline in the number of weekly hours worked also points to a softer, but still solid, labour market. The unemployment rate fell to 3.5% in June and the rate of wage gains increased versus the previous month.
The University of Michigan consumer confidence index and the Conference Board index returned to their highest levels since October 2021 and July 2021, respectively, thanks to a buoyant labour market and slowing inflation. At the same time, small business owners are talking of difficulties in hiring, weaker demand, and rising costs. The National Federation of Independent Business (NFIB) index, which measures small business owners’ confidence, has been significantly below its long-term average since January 2022. One reason might be the average rate that these entrepreneurs report paying on short maturity loans: 8.5%, near the highest reading since June 2007.
Inflation concerns in China
Last week, we presented our central scenario on China’s economy, highlighting a non-negligible risk of China missing its 5.0% GDP growth target this year. It remains to be seen whether the recent news on deflation in China will serve as a trigger for more government stimulus measures. The fall in inflation from 2.1% year-on-year in January to -0.3% in July is worrisome and suggests the recovery is losing steam. The sharp drop in exports and, above all, imports, in July, reinforces that impression.
President Biden issued an executive order on 9 August regulating US investment in Chinese tech companies, prolonging existing restrictions on the sector. Beijing reacted sharply, saying it will closely follow this development and may retaliate, although its response could also include moves to support growth and reassure international investors.
The economic outlook seems more supportive to us of bond markets: A slowdown in economic growth could all too easily end up in recession. In the meantime, bond carry is increasingly attractive.
Given the rally in equity markets this year, relative valuations – as measured by the spread of bond yields over equities – favour bonds versus equities. Even in absolute terms, equity valuations look stretched, with the gains in markets this year largely due to multiple expansion (particularly in the case of technology stocks), rather than higher earnings.
From a technical perspective, we believe investor sentiment is over-optimistic, while other factors (positioning, lack of hedging, limited volumes) are also sending warning signals.