Answering the tough client questions

Authors: Global Investment Strategy Group

 

A sense of unease has grown around the path of central bank policy and the macro outlook, driving bond yields higher and equities lower. As has been the case all year, consensus expectations continue to be challenged, this time it is not about whether or not the Fed will move but rather how long they will keep rates elevated. In turn, consensus views across the Street have been challenged over the past several months.

Over the past few weeks we held a number of in-person events across Asia where we received a range of questions around our view. In this note, the Private Bank Investment Strategy team takes on the most difficult and most asked questions we received from investors.

1.  Can yields go to 6-7%?

After a historic tightening cycle, the Federal Reserve paused at the July Federal Open Market Committee (FOMC) meeting. Yet policymakers projected a much rosier growth outlook; not only doubling their 2023 GDP forecast (from 1.0% to 2.1%), but also raising their 2024 outlook. The Fed is also no longer expecting any meaningful weakness in the labor market. Concurrently, the dot plot now shows another hike in 2023, with rates staying at 5.1% in 2024, and 3.9% in 2025. 

Given the meaningful progress on U.S. inflation, we think a further hike from the Fed is unlikely. We think rates are finally peaking as more disinflation takes place in 2024 the Fed will likely have room to begin normalizing interest rates downward. That said, there is clearly a shift in the market narrative as recession-obsessed investors throw in the towel. At the intermediate to long end of the curve, this capitulation has exacerbated the poor demand and supply balance. In addition, technical factors such as positioning, as well as the chorus for more risk premium, are all pushing yields higher. Given the recent momentum behind the sell-off, it is difficult to say if yields on 10-year U.S. Treasuries will not rocket to above 5%, or if the 20-year and 30-year segment could sell off even more. However, to directly answer the question: 6-7% still seems too high, but investors may need to brace for an overshoot in the near term. Why do we think that? Treasury yields tend to follow the Fed Funds rate over time. We do not think rates are going higher, and current market expectations of a 4% Fed Funds rate over the longer term appear unrealistic. 

Are long-run neutral rates truly shifting? Many are arguing that rates are going structurally higher, as A.I. could power more productivity improvements. But at the same time, the overall debt burden is also much higher than even ten years ago, so normalizing towards a much higher neutral rate is easier said than done. There is also more cyclical weakness ahead in the consumer sector, and also likely amongst corporates, who are less well-prepared for higher interest rates. For these reasons we do not think U.S. rates across the curve can be sustained at 6-7%.

2.  How should I allocate between short and long-duration fixed income?

In the U.S. we are likely near the peak of this cycle’s Fed Funds rate. As such, the cash rate has also likely peaked, and investors could continue extending some duration to lock in yields. We think yields on 2-year core bonds are attractive. It is a compelling investment that can combine income, safety, as well as diversification benefits. For clients who are building three-to-five-year portfolios on an asset allocation basis, shorter-duration core bonds can go a long way towards boosting returns and lowering the volatility in a portfolio.

Intermediate duration (3-10 years) is still on an inverted curve. As mentioned above, the combination of stronger growth, a more hawkish Fed, and term premium, has put upward pressures on yields, with a bear-steepening bias. Since end-July, the 3-year yield has moved up by 30bps, whereas the 10-year yield has moved up by 60bps. We think there is sufficient asymmetry in this part of the curve to warrant some tactical positioning. In other words, over the rest of this cycle there is likely more downside than upside to yields. The difficulty is in timing when yields can start heading lower again – and pin-pointing the exact trigger point is difficult. Thus, managing your position with discipline, or utilizing strategies that can help to smooth out the return profile, are likely more appropriate.

Long-dated bonds (20 to 30-year) will likely face disproportionate pressures in this cycle. Since end-July, yields on 20 to 30-year U.S. Treasuries have risen by 70bps. Nonetheless, the asymmetry in risk and return is not yet clear. The demand/supply imbalance is worse in this part of the curve, meaning term premium could go higher. A soft-landing narrative means these yield levels may need to normalize upward, rather than downward. So while this part of the curve has become more undervalued, the opportunity is also similar to distressed assets, with more potential upside but also a higher degree of risk.

In addition to U.S. core bonds, UK and European rates are also interesting to consider. Economic growth is likely slowing faster in these two regions than in the U.S. As a result, markets could move to price in a lower peak, plus faster and earlier rate cuts than in the U.S. – meaning more capital appreciation potential in the near-term. That said, UK and Euro currencies will likely also weaken if the growth profile starts to weaken materially. Strategies that can take FX considerations into account could be appropriate.

3.  U.S. equity valuations are expensive. Why do you still see more upside?

Valuations for U.S. markets – specifically the S&P 500 – remain a hot topic of debate among investors. Since the start of the year, the S&P 500’s next 12-months (NTM) price-to-earnings (P/E) has expanded from 16.5x to just under 18.5x, and while lower than the 5-year average, is now higher than both the 10-year and 25-year averages. Before delving into why we believe a P/E of ~19x can be justified, it is worth noting that over the past 25 years a 19x forward P/E has been in place for ~20% of all trading days, and is not that rare an occurrence.

Much has been made of the stellar performance of the Magnificent 7 (Apple, Microsoft, Alphabet, Amazon, Nvidia, Tesla, Meta) that now collectively represent a staggering ~28% of the S&P 500. It is worth noting that the equally-weighted S&P 500, formed by giving each company in the S&P 500 the same 20bps weighting, has a valuation at just 14.9x, below its five, ten, and 25-year averages. Thus, the valuation re-rating has been narrowly focused on the Magnificent 7, and the broader market is inexpensive relative to five, ten, or 25-year averages. We currently do favor both the equally-weighted S&P 500 and S&P 400 mid cap index relative to the market-cap weighted S&P 500, due to their valuation discounts. In fact, the median stock in the S&P 500 is largely flat year-to-date.

That being said, there are good justifications for why S&P 500 valuations have expanded over time. In particular, the S&P 500 has become more growth-oriented. Between Tech, Healthcare, Consumer Discretionary (predominantly Tesla and Amazon), and Communication Services (which now includes mega-cap growth firms such as Alphabet, Meta, and Netflix), 60% of the S&P 500 now exceeds the average index growth rate by 200-300bps. This change in constituency argues for both a sustained higher earnings growth rate and valuation, especially if A.I. is truly a driver of future Tech profit growth. With the S&P 500 trading at just a small premium to its 10-year average, we do not view it as particularly expensive, and would look to add at the 4,200-4,250 level.

4.  What could be the catalyst for Chinese equities to recover?

China’s economic growth momentum picked up in August. Consumption rebounded and investment growth showed signs of firming, helping to reverse the slowdown in July. As more cities continue to adjust their property market policies, housing sales could be finally stabilizing after a brutal summer. This could pave the way for economic growth to cyclically bottom out in Q3, after the deceleration in Q2. That said, there are still some uncertainties as to how policymakers could tackle the property market slump and we remain cautious. Local government debt restructuring is also still at an early stage. By now it is well understood that policymakers have little appetite for conventional monetary and fiscal stimulus, yet more innovative approaches carry more risks of the unknown. From a medium-term perspective, the challenge is how quickly China’s economy can transition away from the property market and on to new growth drivers. Markets are by nature forward-looking, but more visibility from Beijing’s policymakers is needed in order to guide investors through this very challenging growth transition.

Based on our recent conversations with investors, beyond the uncertainty on the growth front there are also other concerns. Top of mind is whether geopolitical tensions could rise next year as we head into the U.S. elections. In addition, the recent back-up in U.S. yields raises the risk of “higher for longer” interest rates, along with a stronger USD and weaker growth in emerging markets. While not our base case, we will likely need to see some easing of such concerns for investor sentiment to improve sustainably.

Apart from a macroeconomic recovery, any meaningful earnings upgrades driven by margin improvement or sales growth could also play a role in triggering a re-rating in Chinese equities. So far Q2 earnings announcements have been encouraging, especially from the internet sector, which has undergone a severe earnings downgrade in the past two years. In particular, we are constructive on the internet and consumer sectors for their strong earnings recovery momentum.

Admittedly, the overall China beta environment has become increasingly challenging, with select sectors suffering massive earnings downgrades that escalated equity risk premiums. Not only is the healthcare sector undergoing one of the biggest regulatory storms in history, but property-related sectors (e.g. property developers, management service companies, basic material suppliers, banks, trust companies etc.) are also suffering from contagion risk. Stock selection has become increasingly important.

We prefer stocks that are unrelated to the property supply chain and have high earnings visibility (with upbeat earnings guidance), low regulatory risks, strong balance sheets and good positioning for the ongoing consumption recovery. This thesis leads us to a few investment themes: 1) China Consumer Recovery, 2) China State-Owned Enterprises (SOEs), and 3) Asia High Dividend. We would continue to avoid property, banks, health care and electric vehicles.

5.  Is now still the right time to invest in alternatives?

Many challenges facing today’s investors are universal: Inflation drives the need for higher expected returns to protect purchasing power. Alpha opportunities have generally become harder to find in “traditional” stocks and bonds, and bond volatility has led to investors seeking more reliable portfolio protection. Furthermore, the appetite for steady income generation is ever-present. Alternative investments can continue to help investors address many of these challenges, even under today’s challenging conditions.

• Access to a broader opportunity set of long-term growth potential: Private equity returns have been consistent, generating outperformance to global public markets by 5–10% annually. Vintages that immediately followed public equity bear markets also often delivered above-average returns. Growth equity – which primarily invests in mid- to late-stage tech companies – offers access to industry sectors that can be hard to reach via public markets.
• Attractive yield generation: On the investment risk spectrum, private credit lies between equity and riskier types of fixed income, and it has significantly outperformed traditional fixed income in recent years. We think it could benefit under current market dynamics in which traditional lenders are backing away from lending. Furthermore, in periods of economic and market stress, private credit managers with capital to deploy can demand more favorable terms on the loans they provide. Investors can potentially earn higher yields, and benefit from more restrictive underwriting and covenants offering lender protection. We think current yields provide investors adequate compensation for the risks they take.
• Diversification and dislocation opportunities: Over various market cycles, the inclusion of real assets in a portfolio can be a valuable tool for constructing well-balanced and resilient portfolios. Private real estate has been consistently keeping pace with inflation and delivered higher income returns than other traditional asset classes with limited correlation and volatility. Although there are concerns around real estate, the stress is relatively contained, with varied risks across sectors. Taking U.S. commercial real estate (CRE) as an example, the underlying trends in the CRE space are mixed, and CRE debt markets, especially for offices, could remain dislocated in the foreseeable future given the rate environment, regional bank distress and near-term loan maturity cliffs. We believe this can create a scalable opportunity set for both real estate equity and debt investors.

All market and economic data as of September 28, 2023 and sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.

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Index Definitions

Standard and Poor’s 500 Index is a capitalization-weighted index of 500 stocks. The index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. The index was developed with a base level of 10 for the 1941–43 base period.

Standard and Poor’s Midcap 400 Index is a capitalization-weighted index which measures the performance of the mid-range sector of the U.S. stock market. The index was developed with a base level of 100 as of December 31, 1990.