2 / Outlook and changes

On September 5^th, DWS’ new 12-months forecasts for economic and asset class targets were formulated. Our economic base case scenario continues to assume a soft landing in the U.S. and a gradual reacceleration in the course of 2025. Elsewhere in the world economic activity is muted but not falling off a cliff.  An important change is that, unlike in the past 20 years, China is no longer the locomotive of the global economy. In fact, it is quite the opposite: hit by the housing crisis and weak domestic demand, China is exporting its manufacturing surpluses into Europe and the Americas. Although the recently announced plethora of stimulus measures might help the domestic economy somewhat, we remain skeptical about their ability to produce a longer-term boost for China or developed markets. Therefore, our base case scenario is very much dependent on three U.S. factors, leaving aside global geopolitical risks.  First, we expect improved U.S. consumer sentiment post the election. Second, an ongoing Fed rate cut cycle that does not create new inflation worries at the longer end of the interest rate curve. And third, no major setback to the Artificial intelligence (AI) story which keeps driving corporate capital expenditures at a high pace.

Before we delve deeper into the strategic outlook for the single asset classes, a quick recap of the tactical changes made in September. In the middle of the month, we upgraded U.S. Investment Grade (IG) bonds to Neutral, as we expected the pressure on spreads due to the previously high supply to subside. More recently we upgraded the 10-year Italy-Bund spread to +1, as Italy’s 2025 budget discussions seem to have gone more smoothly than expected.

 

2.1 Fixed Income

Fixed Income remains an attractive asset class as we continue to expect the yield curve to normalize further, meaning that short-term yields come down while long-term yields stay elevated or even increase slightly. We still see the best risk-adjusted returns at the short end of the curve and in European Investment Grade credit assets.

 

Government Bonds

As the downside risks to growth and inflation have increased, we believe that both the Fed and the ECB are switching their focus from inflation to the labor market. We forecast that the ECB will cut without delay towards a deposit rate of 2.5% by September 2025 and expect the Fed funds rate to be cut from the current 4.75 to 5% to 3.75-4.00% by September 2025. Markets are pricing in more cuts but we believe that the central banks will only do this if economies weaken by more than we expect. Bund yields will, in our view, be rather stable, with 2.00% and 2.25% yields for 2- and 10-year Bunds respectively by September 2025, a slight rise at the longer end as economic growth will improve. For the U.S. we expect something similar, a 3.60% 2-year Treasury yield in a year’s time, close to the current level, and a slight rise to 4.05% for 10-year Treasuries as growth improves, while public debt keeps on increasing. Our preference is for U.S. maturities of 2year-5year.  

In Japan we believe the cautious hiking cycle will continue, but the timing is extremely difficult to predict. Our main scenario is for two policy rate hikes within the forecast horizon to a key rate of 0.75% as wage increases continue. We think that 30-year Japanese Government Bond (JGBs) look strategically attractive on a hedged basis for European investors. Equally, for global investors that invest in British pounds, the total return on UK government bonds still looks attractive on an unhedged basis.

 

U.S. Treasuries and German Bunds went different ways in September

^{Source: Bloomberg Finance L.P., DWS Investment GmbH as of 10/2/24}

 

Corporate Bonds

We remain positive on Euro IG Credit, although the room for further spread tightening seems limited. While spreads are tight, all-in yields remain attractive, especially if the U.S. doesn’t fall into a recession and Europe’s manufacturing sector gains pace. Covered Bonds remain an attractive opportunity in the high-quality space. EUR High Yield (HY) looks interesting on a pure return basis, but less compelling on a risk-adjusted basis.

In the U.S., credit spreads continue to be near multi-year tights, amidst strong supply and positive fund flows. A soft landing and a less restrictive monetary backdrop may extend gains further. The expectation of further Fed rate cuts could be a catalyst for investors to move from money markets to longer duration fixed income, even if valuations and fundamentals remain neutral. On U.S. HY we are negative as we believe spreads are relatively tight given an economic outlook in which there is still some possibility of a recession. There are, however, still opportunities, we believe, in more defensive business models that could potentially benefit from lower borrowing costs.

 

Emerging Markets

In emerging markets we expect the spreads on U.S. Dollar (USD)  sovereign bonds to tighten as lower rates in the core markets such as the U.S. and Eurozone should be supportive for spread asset classes. Some Investment Grade (IG) names already have tight spreads but remain attractive against Developed Market bonds. We see value in some “BBB”-rated issuers. We also feel several HY names are attractive, though we remain selective as some of these credits have downside risks. The Euro (EUR)-denominated bonds of various IG and HY sovereigns have attractive yields. Also supportive for this asset class technically is a very low level of new issuance. The flow picture is an important driver for these credits. A recovery in inflows might occur if U.S. yields fall, leading to a more attractive relative value assessment for spread asset classes.

Volatility of credit spreads increased in the third quarter

^{Source: Bloomberg Finance L.P., DWS Investment GmbH as of 10/2/24}

 

Currencies

The Dollar is expected to weaken against the euro as the Fed starts to cut rates. However, as the Eurozone’s economic narrative is currently far from convincing, we don’t expect the Euro to rise far. The Bank of Japan is on the opposite path to the Fed and is expected to raise rates further into 2025. The Yen should benefit though the pace of appreciation is likely to be low given that Japan still has a sizeable rate differential to the U.S. Meanwhile we believe the British pound has the potential to continue to move higher against the dollar. The UK’s economic recovery should continue as the Labour government is poised to improve the country’s relationship to the EU. The pound is our top pick currently.

 

2.2 Equities

We are raising our 12-month targets again across most regions (S&P 500: 5.800 /DAX 20.000). Provided recession is avoided, we forecast company earnings will continue to rise by 5-10% over the coming years, making it difficult to come up with a bearish scenario for global equities. As equity investors, we assume that the U.S. will be able to carry out orderly elections. We currently see a Harris victory as the most likely outcome and think that a divided government is likely, making it difficult to pass bigger legislative changes. We are closely monitoring the differences between the two main candidates’ corporate tax policies.

Some of the global mega-large caps seem particularly expensive. We expect that the U.S. “Magnificent Seven” will continue to deliver the expected strong earnings per share (EPS) growth. However, their share prices are unlikely to return to their previous all-time highs without powerful new evidence that the epic AI capex spending is justified and likely to deliver high returns for shareholders. Therefore, we reduced our AI exposure in late July, downgrading the communication services sector to neutral. At the same time, we upgraded health care as our preferred sector. Health care offers a combination of defensive qualities and the scope for innovative growth, and valuations are reasonable. We expect double-digit EPS growth for the global health care sector in 2025 and 2026. Health care reform is not big on the agenda of either U.S. presidential candidate, reducing the near-term risk in our opinion.

Strong performance of U.S. and German equities for different reasons

^{Source: Bloomberg Finance L.P., DWS Investment GmbH as of 10/2/24}

 

As the Fed’s change in monetary policy materializes, we expect continued broadening of global equity market leadership. Valuations remain most stretched in “growth.” On the other hand, “pure value” is suffering from weak economic growth, especially in commodity and China-sensitive sectors. Therefore, we believe “blend” will be the best near-term equity style for global diversified portfolios.

 

We reiterate our overweight of European large and small cap stocks due to robust EPS growth and attractive dividend yields (Stoxx 600: 5% EPS growth in the next 12 months and a 3.5% dividend yield / small and mid-caps: 11% EPS growth, 2.5% dividend yield) as well as low valuations (both trade currently at an PE-ratio of 14 vs. 21.5 for the S&P 500).^[3]

In Japan we welcome visible progress in corporate governance, with cross-shareholdings being reduced and cash hoarding giving way to share buybacks. We are refraining from upgrading Japan as we first want to see how the shrinking yield differential between the U.S. and Japan plays out on the currency market. While the strengthened yen has reduced the earnings tailwind, we would still judge levels of 140 USDJPY as offering a competitive advantage for Japanese exporters.

Elsewhere in Asia, we focus on select semiconductor, technology, and consumer stocks. The Indian stock market is shining, with strong macro fundamentals and earnings growth. However, unfortunately, international large cap investors are struggling to get access to the domestic market due to high regulatory hurdles.

 

2.3 Alternatives

The situation in alternatives can be summed up in three factors: lower central bank key interest rates and a steepening yield curve; an okayish economic backdrop; oil stable at a low level and gold going from strength to strength.

 

Real Estate

Real estate prices are stabilizing, and in some cases increasing. Fundamentals are mixed across sectors and markets but healthy overall. Plunging construction starts will tighten supply conditions in 2025. High yields and strong rent growth (supported by minimal supply) should drive the next cycle. There is further upside potential if interest rates decline. We see strong structural demand drivers in logistics (e-commerce) and residential (housing shortages) in every region. Our main calls are: Logistics. Markets are tight as e-commerce keeps on fueling demand for distribution capacity around the world. Residential: Housing shortages in most major markets. High home prices are causing demand to shift to rentals. Commercial Real Estate: U.S. office space is still weak; working from home is expected to have a lasting impact on demand. In Europe and Asia-Pacific (APAC), however, office space is more resilient.

 

Infrastructure

Early signs show the performance of unlisted infrastructure has moderated in 2024, with the drop in inflation limiting the ability to offset higher rates and the tepid economic outlook. Limited liquidity has prevented a full fundraising recovery in the first half of this year but the improvement in 2023 and rate cuts should unlock more deal flow.

 

The fundamental policy environment remains positive; our preference is for Europe which has more developed demand-side policies for numerous energy transition sectors. Fundraising has picked up, but the transaction market is not recovering rapidly and has seen liquidity in the market suffer. Rate cuts should see some build up in momentum. Our main calls are as follows. Energy transition assets which do not require new markets to develop e.g. drop-in fuels. Airport transactions that are coming to market – there is a fundamental recovery in demand and the opportunity to add value through the conversion to more Sustainable Aviation Fuel (SAF). Data center demand continues to be one of the strongest thematic investments in the infrastructure market.

 

Gold

We have raised our gold forecast yet again to USD 2,810/oz for September 2025. Gold has reached all-time highs recently on rising expectations for Fed interest rate normalization, a weaker dollar, and persistently elevated geopolitical risk. While we see relatively balanced risks near-term, we expect rising fiscal deficits coupled with rising global money creation as continued bullish factors for the yellow metal.

 

Oil

Our forecast of USD 80/barrel Brent reflects ample supply near-term, with additional OPEC+ barrels potentially entering the market in 4Q 2024, along with further production increases planned for 2025. Our base case assumes a very gradual increase in OPEC+ volumes and matching moderate growth in crude demand, consistent with DWS’s view of the global GDP path. Recent events in the Middle East have heightened geopolitical risk premiums, leading to increased volatility in global crude oil prices.

 

Oil price mirrors weak demand and increasing supply while gold goes from strength to strength

^{Source: Bloomberg Finance L.P., DWS Investment GmbH as of 10/2/24}

3 / Past performance of major financial assets

 

Total return of major financial assets year-to-date and past month

 

 

 

 

 

4 / Tactical and strategic signals

 

The following exhibit depicts our short-term and long-term positioning.

 

 

4.4 Legend