Notes from the road: key questions and answers for today’s market

Author: Asia Investment Strategy team

 

Markets have remained strong in a fragile global landscape. Amid tight monetary policy, tech innovation and frequent geopolitical ruptures, investors have had a challenging time building resilient portfolios. In this context we think investors need to think internationally, plan strategically towards long-term goals, and structure investment portfolios to take advantage of a myriad of risks and opportunities – all while navigating a rapidly shifting geopolitical and macro environment.

As we traveled across the Asian region this week meeting clients we surveyed these investors’ views on the current landscape, and provide the results of various polls here. In this note we also address some of the common questions we encountered, and provide recommendations for implementation of these ideas within portfolios. 

Yields have fallen significantly as the Fed begins cutting interest rates – should I wait for a rebound before entering fixed income?

At the September FOMC meetings the Fed cut its policy rate by 50 basis points to 4.75%–5.0% from 5.25%–5.5%, marking the first cut to interest rates in four years.

We think the Fed is moving into a new stance. In the Fed’s eyes, the recent slowing in the labor market is now a bigger risk than inflation. A lot has changed very quickly. Since early August, rising concerns about labor market weakness coupled with falling inflation have resulted in a meaningful shift in the Fed’s focus – away from managing inflation and towards supporting growth. This rate cut, and the plans to lower rates further, are designed to ensure the economic cycle continues.

As a result of the rapid changes in market expectations, the curve has shifted meaningfully lower. The 2-year Treasury yield declined from 4.1% to 3.5% in one month. The 10-year has declined to 3.6%. Embedded in these shifts are expectations that the Fed plans to cut to around 2.9% by end-2025 (according to Fed Funds futures).

From our perspective, while these moves are not unreasonable, market expectations of Fed rate cuts are historically large at the start of a cutting cycle (250bps), especially given a soft-landing base case for the U.S. economy. Of course, markets can overshoot in the near-term, but a risk management approach is warranted given how much and how quickly markets have already moved. Although yields have declined, fixed income still makes sense for the downside defense it offers a portfolio. In the event the consensus soft landing view is wrong and a recession materializes, historical index performance suggests fixed income tends to outperform most major asset classes. While there is not a significant uptick over cash rates, bonds offer crucial portfolio diversification. 

Since the beginning of the year we have been recommending that clients lock in yields with an eye on the rate cut cycle to come. That was the easy part. It was also the right thing to do as it helped to hedge client portfolios through the equity market drawdowns this year – where stock-bond correlations turned negative. At this juncture, as yields have already declined so much ahead of this well-telegraphed September meeting, entry points have become much less attractive. We would advise a differentiated approach.

For clients with little to no fixed income exposure, or a long time horizon, we think you can still consider this asset class for stable long-term income. Certain segments of the market provide a higher yield than Treasuries or investment grade credit, and these are accessible through active managers. Lastly, qualified investors can also consider using structured products to enhance their near-term yields (usually one year or shorter), with the underlying linked to certain types of fixed income instruments. As some clients have remarked, right now feels like one of the most difficult moments in this whole cycle to invest into fixed income. To some degree it’s true, but it’s also important to acknowledge that fixed income is an essential part of a diversified portfolio and plays an important role in diversification and hedging.

Equity markets have rebounded and are near all-time highs – where can we find opportunities?

With modest upside to our S&P 500 June ‘25 outlook of 5,700-5,800, it is time to be more selective and seek out idiosyncratic opportunities. There remain a number of single stocks where fundamentals have not deteriorated, but sentiment has soured and driven meaningful double-digit declines from their recent 52-week highs. We are of the view that stock selection in this segment of the market offers attractive upside. Many of these companies are exposed to the Artificial Intelligence (AI) theme, where demand through 2025 offers reasonable visibility, and we remain constructive on the potential applications of this emerging technology. Weak market seasonals in September and October (of this Presidential election year), coupled with investor angst amid slowing economic data as the Fed cuts rates, are all likely to keep U.S. equities choppy. With this in mind, volatility is likely to stay elevated over the next one to two months. To capitalize on this, structured products with downside defense offer attractive opportunities, and we also recommend ‘buying-the-dip’ in the S&P 500 closer to 5,200-5,300.

Sentiment towards U.S. equities continues to be positive among many of our clients. A majority of attendees were constructive towards U.S. equities and expect the S&P 500 to be higher by year-end. In addition, one-third of attendees also intend to allocate more towards equities over the next 12 months.

Chinese equity valuations appear attractive – is it time to enter the market?

Many clients believe Chinese equities will end 2024 lower, underperforming U.S. markets. This reflects the market’s general pessimism on China, and this is not surprising. On a positive note, barring another major decline in economic activity, this also means incremental selling pressure could be limited. Some investors also hope that the start of a U.S. rate cut cycle may support Chinese equities, but we are doubtful. In order for investors – especially those that are foreign – to revisit China, they need to have conviction in a sustainable economic recovery, which is yet to be seen.

We remain fundamentally neutral on China and we expect major indices to stay range-bound in the near-to-mid-term. Indeed, inexpensive valuations (<9x P/E or -1 standard deviation below averages) provide support on the downside, but the upside potential is also capped by deflationary pressures. Consensus earnings estimates are still too high (MSCI China forward EPS growth at ~13% YoY) and downward revisions are likely needed. A lack of significant fiscal support leaves economic growth subdued. The property market is still lukewarm, with high inventory levels and depressed sales volumes. Earnings downgrades in consumer stocks are still ongoing and could even accelerate as consumption downgrades are broadening to different sub-sectors following growing unemployment and salary cuts. Geopolitical tensions are also a concern, with the U.S. announcing new measures to crack down on low-value Chinese imports. 

Tactically, we would turn more constructive on offshore China when the Hang Seng Index/MSCI China approach the 16,000/52 mark. For the onshore China market, poor consumption sentiment has pushed the market to YTD lows, and we believe a lot of negativity has been priced in. Investors who plan to add onshore China exposure can consider phasing in at below 3,200 for the CSI 300. High-dividend stocks listed in Hong Kong, which pay an average of over 7% in dividends, remain our preferred equity segment in China. 

Gold is at record highs – why should I enter now?

Gold has been one of our high conviction calls this year, delivering a strong 25% YTD return. One of the pushbacks we received is whether the yellow metal has rallied too much. While we think it’s a valid concern and the most rapid part of the rise is likely behind us, we still see gold prices well supported for several reasons.

Historically, the value of the U.S. dollar is often negatively correlated with gold prices, as the metal is priced in dollars. When the USD weakens, gold becomes relatively less expensive holders of other currencies, leading to increased demand. At this juncture, we are entering a different USD regime than the past two years, when it has been difficult to bet against the dollar (as the currency with the highest carry in the G10). Now that the Fed is moving into an easing cycle we will likely see dollar strength fading to some extent, lending support to higher gold prices.

Fed easing will likely also push down real yields (i.e. inflation adjusted interest rates). As gold itself does not generate interest income, real yields can be seen as the opportunity cost of holding the metal, and thus the correlation between the two has historically been negative. Since 2022, this correlation has become more asymmetric: gold declines less when yields go up and rises more when yields move down, due to strong central bank buying. We think this dynamic will likely hold, and lower yields can help further push up gold prices.

We think gold can potentially reach new highs over the next 12 months, though returns could be lower than the past year. Returns aside, gold allocations can add multiple benefits to portfolios as a diversifier, an effective hedge to geopolitics/risk events, and a long term store of value.

How much does the U.S. Presidential election really matter for markets?

While election years and administrations matter less for long-term returns compared to market fundamentals, there are important nuances in the specific elements of each candidate and the policies of their respective parties. These differences matter for certain markets at a more micro level. Clients can take action to make their portfolios more resilient to the themes outlined below:

• Trade: A Harris victory could mean a continuation of the Biden administration’s targeted tariffs on strategic sectors, while a Republican win could mean more broadly-applied tariffs – not just on China, but on the rest of the world, including key U.S. trading partners like Europe. The former would be less impactful on the dollar, while the latter could lead to a stronger dollar relative to the currencies of its trading partners.
• Energy and regulation: A Democratic win would be a boost to renewables while a Republican victory would favor traditional energy, and particularly energy services. A Trump victory could result in lower energy prices on increased supply, so while not uniformly good for the sector, certain aspects like those servicing drillers could outperform. The latter scenario could also result in looser corporate regulations, giving a boost to small/mid-caps and banks.
• Foreign policy: A Democratic win could mean a continuation of Biden’s multilateral efforts to engage with global allies and support partners including Ukraine and Taiwan, while a Republican victory could mean a more unilateral approach and reduced support for those partners. Regardless, defense spending is poised to structurally increase given the tense geopolitical environment, and beneficiaries pricing in higher expected capex in that space.

One aspect of policy that could have a bigger market impact is in the fiscal space. However, significant tax and budget changes would likely require a one-party sweep in Congress, which appears to be a less likely outcome than a split Congress, at this moment. However, the current fiscal trajectory of the U.S. is unlikely to shift significantly as the deficit continues to worsen.

Even so, we do not think that a crisis – either in the U.S. dollar or Treasuries – is likely in the near-term, as there does not appear to be a viable alternative for now (given the also challenging debt situation of most developed economies). Gold could be a useful hedge for such a tail risk (as mentioned above). Real assets such as infrastructure and uncorrelated assets like hedge funds can provide diversification.

Hedging currency risks (such as CNH) and investing into defense and supply chain redirection beneficiaries could be active ways to take advantage of those structural shifts described above. Geographical diversification and reducing home bias remain key to improving portfolio resilience.

All market and economic data as of September 19, 2024 and sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.

For illustrative purposes only. Estimates, forecasts and comparisons are as of the dates stated in the material.

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Index Definitions:

S&P 500 Index: The Standard and Poor's 500, or simply the S&P 500, is a stock market index tracking the stock performance of 500 of the largest companies listed on stock exchanges in the United States.

MSCI China Index: The MSCI China Index captures large and mid-cap representation across China A shares, H shares, B shares, Red chips, P chips and foreign.

Hang Seng Index: The Hang Seng Index is a market-capitalization-weighted stock market index in Hong Kong, adjusted for free float. It tracks and records daily changes in the largest companies listed on the Hong Kong Stock Exchange and serves as the primary indicator of overall market performance in Hong Kong.

CSI 300 Index: The CSI 300 is a capitalization-weighted stock market index designed to replicate the performance of the top 300 stocks traded on the Shanghai Stock Exchange and the Shenzhen Stock Exchange.