For much of the year, bad news for the economy has been good news for markets. More slack in the US labor market, for instance, was cheered by risk assets2 as a sign that growth and inflation were moderating, and the Fed might achieve a soft landing. Now, though, the other side of this relationship is playing out: A stronger-than-expected economy has pushed the expected terminal interest rate higher for longer, causing stocks to struggle. Meanwhile, still-tight labor markets and rising commodity prices indicate ongoing inflation pressures, at a time when businesses and consumers have yet to fully absorb the impact of higher rates. This could mean a third phase of the narrative in which a weaker economy spells bad news for markets (FIGURE 1).
Services Hooking Lower in Global Economy
Developed-Market (DM) Purchasing Managers Index
Chart data: Manufacturing – 1/98-8/23; Services – 6/98-8/23. Past performance does not guarantee future results. Indices are unmanaged and not available for direct investment. The S&P Global Developed Market Purchasing Managers’ Index (PMI) is an indicator of the economic health of the manufacturing sector. A reading above 50 signals economic expansion; below 50 signals contraction. Source: Bloomberg Finance LP.
While it has taken longer than expected, we think higher rates will hurt the global economy, and a slightly cautious investment stance is still warranted. We’re also tracking several risks still unfolding as of this writing, including US government funding, the spike in oil prices, and the strong US dollar. That said, we’re more sanguine about the resilience of the US economy given several positives we had underestimated: the increase in household net worth from gains in stocks and real estate; low pandemic-era interest rates locked in by consumers and businesses; and plenty of liquidity.
On balance, we still expect risk assets to underperform defensive fixed income, given high valuations for the former and the lagged, but looming, impact of restrictive monetary policy. However, we’ve reduced our underweight views on global equities and credit spreads, and we’re quite close to neutral across our active weights overall. Our highest-conviction views are in Japan: Equities there have finally begun to embrace economic and corporate governance improvements, while slow-drip monetary tightening has left real rates in negative territory and expensive relative to other regions. Among spread sectors, we prefer global investment-grade (IG) credit. We remain moderately overweight commodities with a focus on copper and gold.
Equities: Some Positive Signs, but Keeping Our Guard Up
We’ve raised our view on global equities to moderately underweight but maintain a defensive tilt. We think the lower interest-rate sensitivity of consumers and businesses, and the overall strength of the consumer, make a US hard landing less likely. However, we still believe the distribution of risks for the global economy, and even the US, is skewed to the downside. While the effects of tighter policy are playing out with more of a lag than in the past, there will eventually be a monetary overhang, which implies lower equity valuations and downgrades in earnings expectations.
Our Multi-Asset Views
OW = overweight, UW = underweight
Views have a 6-12 month horizon and are those of the authors and Wellington’s Investment Strategy Team. Views are as of 9/30/23, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may make different investment decisions for different clients. This material is not intended to constitute investment advice or an offer to sell, or the solicitation of an offer to purchase shares or other securities.
The fiscal impulse that has propped up the private sector could become a drag on growth in the US and Europe as they consolidate fiscally.
We think the fiscal impulse that has propped up the private sector could become a drag on growth in the US and Europe as they consolidate fiscally—although the impact may be less noticeable in Europe, where fiscal stimulus hasn’t been fully deployed on the ground. We also expect higher inflation risk globally as the path to further disinflation becomes more fraught. A worsening growth/inflation mix could chip away at margins. Meanwhile, global equity valuations are still expensive in absolute terms and relative to cash. We observe more regional divergence, with the US and Japan outperforming Europe cyclically, and valuations similarly disparate.
We maintain our overweight view on Japanese equities. While the market is no longer cheap, positive economic momentum has fed through to higher margins and earnings growth. The Bank of Japan's (BOJ) decision to add flexibility to its yield-curve3 control policy in July hasn’t challenged the market’s outperformance, partly because the yen has continued to weaken against the US dollar. In addition, Japanese equities continue to show good market breadth.
We have an underweight view on US and European equities relative to Japan. We upgraded our US market view slightly, considering the resilience of the economy and companies’ exposure to artificial-intelligence (AI) trends. But US valuations seem priced for perfection, making them vulnerable to a downgrade in growth expectations sparked by the resumption of student-loan repayments, auto-worker strikes, or any number of other catalysts. Corporate balance sheets still look solid, although we see some signs of weakening in net margins and interest coverage.
European valuations are attractive, and we have more conviction that the European Central Bank has reached the end of its hiking path as the economy has cooled. However, weak earnings momentum and downward adjustments in profitability—in what we believe to be a stagflationary base case—leave us downbeat on equity-market prospects. We also see cracks emerging in the service sector, a negative sign for the labor market and consumer resilience.
We’ve downgraded our China view to neutral, as we’ve been too optimistic on the potential for a cyclical uplift as well as on structural issues holding back sentiment and investors’ willingness to engage. We’re tracking a raft of recent policy measures and signs of cyclical green shoots that suggest we may be at peak pessimism, but also note there are fewer signs of a turnaround in consumer sentiment or the property cycle. The case for emerging markets (EM) ex-China is also finely balanced, with domestic monetary policy easing juxtaposed against a strong US dollar and inflation risks from food and oil.
Regarding sectors, we’re positive on financials and negative on materials. We expect financials to be supported by strong corporate fundamentals as well as continued positive sentiment, while we expect the materials sector to struggle given weaker return on equity and higher return volatility.
Government Bonds: Interest Rates Going Higher Still?
Several factors drove government bond yields around 50 basis points4 (bps) higher in the second quarter. First, longer-maturity real yields rose as markets embraced the Fed’s mantra of “higher for longer,” which translated into expectations of a higher fed funds rate5 for a longer period. Second, the term premium6—which compensates investors for duration7 risk—widened to reflect greater long-term inflation uncertainty and rising US public debt (which, among other things, prompted Fitch to downgrade US government debt in August). Finally, the BOJ took the first step toward tightening monetary policy by relaxing its yield-curve control and allowing 10-year government bond yields to rise to around 50 bps. While this doesn’t seem particularly dramatic on its own, 0% rates in Japan anchored rates in other regions to some extent.
Growing evidence suggests that the Fed is at a restrictive enough stance to slow the US economy.
So, are rates likely to go even higher? We remain moderately overweight duration overall, due to the mixed picture on global growth and attractive valuations in the US with real yields at 2.5%. Growing evidence that the US economy is getting pinched by higher rates suggests that the Fed is at a restrictive enough stance to slow the economy. European growth has notched down and looks recessionary. Therefore, we favor US and European duration relative to Japan (FIGURE 2). The risk is that the US term premium widens further, either in response to the Fed losing credibility in its inflation fight or because markets demand a larger term premium for being a creditor to a highly indebted government.
Wide Gap Between US and Japanese Real Rates
Difference Between US and Japanese Real Yields (%)
Chart data: 1/97-7/23. Difference between US 10-year inflation indexed Treasury yield and Japanese 10-year yield based on headline CPI. The Consumer Price Index (CPI) is a measure of change in consumer prices as determined by the US Bureau of Labor Statistics. Source: Bloomberg Finance LP.
Credit: Not Out of the Woods, But Looking for Opportunities to Add on Weakness
As noted, the global economy has been surprisingly resilient, and inflation has come down quickly, particularly in the US, leaving us with less conviction around the severity of a potential recession and credit downturn. Still, we remain in the late stages of the credit cycle with compressed valuations, tightening credit conditions, and some weakening in corporate balance sheets and cash levels, albeit from very high levels (FIGURE 3). Despite the risks being somewhat skewed to the downside, spreads may remain rangebound for some time in the absence of a clear catalyst for widening—an environment in which we expect credit income to dominate returns.
High-Yield Credit Fundamentals Are Deteriorating
Cash to Assets of Median US High-Yield Companies
Chart data: 1/98-8/23. Cash to assets (dark blue) represents median value based on ICE BofA US High Yield companies. Light blue line represents the expanding mean. ICE BofA US High Yield Index tracks the performance of US dollar-denominated below-investment-grade-rated corporate debt publicly issued in the US domestic market. Source: Wellington Management, Worldscope, and Compustat.
Taking these competing factors into account, we’ve upgraded our view on credit spreads while remaining marginally negative on the asset class in the near term. There may be opportunities to add on weakness considering the more positive starting point for yields, which are a strong determinant of long-term returns. We prefer higher-quality credit in this environment, and, therefore, remain more positive on IG credit relative to high yield.
We have downgraded our view on EM hard-currency debt relative to global high-yield corporate bonds, a decision driven by the economic resilience in DMs compared to EMs, as well as our inclination toward a slightly less defensive position in credit.
Commodities: Taking a Shine to Copper and Gold
We maintain our moderately overweight view on commodities, driven by positive views on copper and gold. In the copper market, we expect favorable long-term supply dynamics and robust demand spurred by spending on the global energy transition. While we continue to monitor the challenging macro environment in China and its impact on copper demand, we’ve observed signs of sustained demand strength, particularly from the housing market.
Gold prices have remained stable in recent quarters, defying the typical correlation with higher real yields, which indicates underlying strength. We think gold could be a reasonably priced hedge in the context of increased stagflation risk, as well as the potential for geopolitical shocks. Concurrently, central-bank purchases in Asia persist as a source of positive demand.
We remain neutral on oil, which has been rallying in recent months with support from a bullish supply backdrop and an improving demand outlook. With the price near year-to-date highs and continued demand risks from a potential global economic slowdown, we prefer to stay on the sidelines and wait for opportunities to engage with the market.
Upside risks include a Goldilocks scenario for the US economy, in which growth remains at or above trend and inflation continues to move toward target, as well as a soft landing in which growth is below trend but unemployment doesn’t spike. For Europe and China, positive outcomes would include a reacceleration in growth, with DM central banks abstaining from further rate hikes or beginning to move toward rate cuts. In addition, further advances in AI or announcements pertaining to the technology could impact mega-cap valuations, with a disproportionate impact on equity markets.
Downside risks include a scenario in which overtightening of monetary policy or renewed financial stress shocks a prospectively weaker US economy into a hard landing. In addition, a bank or property crisis in China could create a negative skew for global growth. Finally, escalating tensions in the Russia-Ukraine war or with respect to US-China relations could have profound negative implications for markets.
To learn more about positioning your portfolio for potential market volatility, talk to your financial professional.
1 Spreads are the difference in yields between two fixed-income securities with the same maturity but originating from different investment sectors.
2 Risk assets refer to assets that have a significant degree of price volatility, such as equities, commodities, high-yield bonds, real estate, and currencies.
3 Yield curve is a line that plots interest rates of bonds having equal credit quality but differing maturity dates; its slope is used to forecast the state of the economy and interest-rate changes.
4 A basis point is a unit that is equal to 1/100th of 1% and is used to denote the change in a financial instrument. The basis point is commonly used for calculating changes in interest rates, equity indices and the yield of a fixed-income security.
5 The federal funds rate is the target interest rate set by the Federal Open Market Committee. This target is the rate at which commercial banks borrow and lend their excess reserves to each other overnight.
6 The term premium is the amount by which the yield on a long-term bond is greater than the yield on shorter-term bonds. This premium reflects the amount investors expect to be compensated for lending for longer periods.
7 Duration is a measure of the sensitivity of an investment’s price to nominal interest-rate movement.
Important Risks: Investing involves risk, including the possible loss of principal. Security prices fluctuate in value depending on general market and economic conditions and the prospects of individual companies. • Foreign investments may be more volatile and less liquid than U.S. investments and are subject to the risk of currency fluctuations and adverse political, economic, and regulatory developments. These risks may be greater, and include additional risks, for investments in emerging markets such as China. • Investments in the commodities market may increase liquidity risk, volatility and risk of loss if adverse developments occur. • Investments linked to prices of commodities may be considered speculative. Significant exposure to commodities may subject the investors to greater volatility than traditional investments. The value of such instruments may be volatile and fluctuate widely based on a variety of factors. • The value of the underlying real estate of real estate related securities may go down due to various factors, including but not limited to, strength of the economy, amount of new construction, laws and regulations, costs of real estate, availability of mortgages and changes in interest rates. • Fixed-income security risks include credit, liquidity, call, duration, and interest-rate risk. As interest rates rise, bond prices generally fall. • Investments in high-yield (“junk”) bonds involve greater risk of price volatility, illiquidity, and default than higher-rated debt securities. • Loans can be difficult to value and less liquid than other types of debt instruments; they are also subject to nonpayment, collateral, bankruptcy, default, extension, prepayment and insolvency risks. • Diversification does not ensure a profit or protect against a loss in a declining market.
The views expressed here are those of the authors and Wellington Management’s Investment Strategy Team. They should not be construed as investment advice. They are based on available information and are subject to change without notice. Portfolio positioning is at the discretion of the individual portfolio management teams; individual portfolio management teams and different fund sub-advisers may hold different views, and may make different investment decisions for different clients or portfolios. This material and/or its contents are current as of the time of writing and may not be reproduced or distributed in whole or in part, for any purpose, without the express written consent of Wellington Management or Hartford Funds.
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