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- Time to bond with bonds
Compared to the years 2020-23, the past couple of months have been rather uneventful in terms of major political or economic shocks. But there were particularly intense discussions during our third CIO Day of the year, in which we formulate our view on the global economy and capital markets for the next 12 months. The main uncertainties in the markets can be boiled down to the following questions: How deep of an economic slowdown is needed to bring inflation down? And what role will labor markets play? What is the reaction function of the central banks, who are just as data dependent these days as we are? And how far ahead are bond markets looking
How deep of an economic slowdown is needed to bring inflation down? And what role will labor markets play?
These questions are made more complex by the fact that the world is dealing with a handful of major structural shifts: easy money has turned into Quantitative Tightening; China is struggling with various internal and external problems, including deteriorating relations with the West; and the Ukraine war has brought instability to Europe. On the positive side, the advance of digitalization and Artificial Intelligence (AI) could raise potential growth in many countries.
Our outlook for equities is influenced by AI and by the outsized role it has played in U.S. equity markets, which we demonstrate below. This is one of the main reasons why we expect higher returns for European than for U.S. equity markets. But we also see macroeconomic factors as being in Europe’s favor. We expect Europe to escape the (mild) recession we are forecasting for the U.S., and we expect Europe’s economy to grow more than twice as fast as the U.S. in 2024 (0.9% vs 0.4%). At the same time the U.S. will suffer another year with a hefty budget deficit (our forecast is 5.6% of GDP) and needs to issue vast amounts of Treasuries that might be met with decreasing external demand, pushing bond yields up.[1]
The further problem for U.S. equities is that the market is split into two. There are the often cited seven U.S. mega caps, mostly from IT and media/internet related sectors, that have benefitted from the AI boom this year. The Nasdaq 100 is up YTD by some 40% and the Dow Jones by just 4%.[2] This in turn means that the valuation gap between growth and value stocks, or between Big Tech and the rest has become significant. U.S. Technology trades at a premium of 47% to U.S. stocks excluding the TMT sector, while the 30-year average for this gap is 20%. And the U.S. market premium to Europe is 56%, against a 30-year average of 20%, and to Germany – the value market par excellence - 70%, compared to an average of 18%.[3]
These gaps from the historical norm are very big and are the grounds for our caution on U.S. equities. U.S. mega-large caps have on aggregate become too expensive to drive meaningful market upside from here. At the same time, a change in market leadership towards cheaper value stocks does not seem imminent. That would require higher than currently forecast GDP growth in the U.S., Eurozone and China. Our relative preferences within equities are: Communication Services, which offers AI exposure at a reasonable valuation and double-digit earnings per share (EPS) growth; Discretionary Consumption, currently supported by robust labor markets; and European small and mid-caps (SMID), as Europe offers "value within value" and SMID caps have a particular high discount to the S&P 500.
Holding back equity valuations are real interest yields last seen in 2009 – the U.S. TIPS yield is now almost 2%, compared to a 10-year average of just 0.28%.[4] And while we believe that the central banks’ hiking cycles[5] are coming to an end this year, the rate cuts we are expecting for next year[6]constitute an interim rate adjustment and not the beginning of a full-blown easing cycle. Inflation will likely come down significantly by 2024 but still not be low enough for central banks to return to neutral rates. This scenario – our central one – is very positive for bond investors. They are benefiting now from interest yields not seen since 2008[7]and might even, the icing on the cake, benefit from slightly decreasing interest yields, which will increase bond prices. We expect more of a decrease at the shorter end than the long end, which means we expect the 2y10y yield curve to flatten in 12-months’ time. For 10-year yields we expect 4.2% for Treasuries and 2.7% for Bunds, for 2-year yields we expect 4.35% and 2.7%. In terms of maturities, we currently prefer the 2-to-5-year segment: although the initial yields are similar, the reinvestment risk[8] is lower (as it is shifted to the back) than it is for shorter maturities such as money markets.
We believe corporate bonds offer a nice interest yield premium to sovereign bonds. We slightly prefer investment grade (IG) to high yield (HY) bonds, as they will be more resilient should the economic downturn prove more marked than we expect. But given stronger fundamentals than in previous cycles, we believe HYs have some yield cushion for the coming months. On Emerging Market (EM) bonds, heterogeneous as they are, we are slightly cautious because of the drag from China, and marginally favor corporates against sovereigns.
In Alternative assets we are not dropping our positive stance on gold, which has held up pretty well over the past 12 months despite strong headwinds from real interest rates – helped by support from central bank buying. The rate increases are ceasing while the latter looks set to remain. Our target price for gold is USD 2150/oz. Oil supply will be more than sufficient over the coming 12 months, with growing contributions from the U.S. and Iran, while China weighs on demand growth. This means we expect that the benchmark Brent crude will trade about evenly over the next year (USD 88/b by next autumn.)
Within the Infrastructure space we see continued strong performance due to inflationary and interest rate pressures. Private markets valuations are holding up well. We expect fundraising and transaction slowdown to reverse in Q3/Q4 2023 as the market settles. Our preferred sectors are Energy, Transport, and Digital, where data centers are appealing.
In real estate, higher interest rates are pricing into valuations with a 6-12 month lag relative to listed markets. But fundamentals remain solid, with low vacancy rates and healthy rent growth across most sectors and regions. Recession might dampen leasing, but construction is also falling amid labor shortages and lack of financing. We prefer logistics due to increasing demand, and residential buildings due to housing shortages.
In summary, we believe that market volatility will increase from now on. Some reality checks are due, not least for China, which is struggling with long-term challenges. Nevertheless, we believe that current sentiment towards China might have reached rock bottom. For investors the good news is that they have a wide range of asset classes that can offer income, upside or protection, according to their preference and market outlook.
