- Global Investment and Multi-Asset Strategist
Asia ex-Japan, Institutional
Change
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Key points
- Global fundamentals look favorable from a growth, inflation, and monetary policy standpoint and support a risk-on tilt despite lofty valuations and political uncertainty. Whether inflation settles lower remains an open question, but central banks are in cutting mode.
- We maintain a moderately overweight view on global equities and would turn more positive on signs that equity market gains are broadening out beyond the mega caps. We expect earnings growth to broaden across regions, as reflected in our neutral regional stance.
- We have moved to a moderately overweight view on duration given signs of moderating growth and inflation, the Fed’s tilt toward policy easing, and market alignment with fewer cuts than in the second quarter. We see tight spreads persisting and express this in high yield.
- We have a slight overweight view on commodities, expressed in oil where the supply/demand dynamics and carry are favorable.
- Downside risks to our views include a resurgence of inflation, US or European political turmoil, and a broader conflict in the Middle East. Upside risks include a resumption of disinflation that drives more aggressive rate cutting, stronger-than-expected earnings outside of mega-cap tech, and a resolution to the war in Gaza.
While economic fundamentals have been a source of relative calm for markets, political noise is rising in this important election year. Whether that will have a sustained impact on markets is another matter. We are loath to predict political outcomes. We have more conviction in our view that the fundamental backdrop of decent growth, moderating inflation, and credible monetary policy has staying power and is bullish for risk assets despite high valuations. In the US, we see signs that growth is slowing and there is a bit more slack in labor markets. Service inflation remains sticky, and specifically shelter, but the path is pointing downward. That leaves the Federal Reserve (Fed) in a position to ease eventually, which will support equities and bonds.
Of course, politics can’t be ignored. The success of France’s right wing in the European Union (EU) elections and President Macron’s announcement of a snap election spooked bond markets last month. Populist-driven spending proposals by the National Rally party on top of a French budget deficit of 5.5% of GDP drove the spread between French and German 10-year bond yields to its widest level since early 2017, when French fiscal concerns also arose. However, we do not see this growing into a systemic issue for a couple of reasons. First, we do not see an EU breakup as a risk, although its fiscal rules and institutional setup face challenges. Second, as we saw in the UK in 2022, France in 2017, and Greece in 2015, markets can impose discipline on politicians when fiscal policies are deemed profligate. Even if a crisis were to ensue, the European Central Bank (ECB) would likely be a buyer of last resort at some level of risk premia spike. We’ll be watching for politically induced market disruptions elsewhere too, but we don’t think they’ll be sustained enough to influence our 12-month view. Ultimately, a divided US Congress could curb spending, while the UK election should be a non-event for markets and may even yield a better outlook.
Confident in the positive fundamental backdrop, we have maintained our moderately overweight view on global equities but no longer have a regional preference. We have raised our view on EM equities to neutral — valuations are relatively inexpensive but politics and the delay in Fed rate cuts are weighing on the macro outlook. Within risk assets, we also favor high-yield credit, given the macro backdrop and the role that lower US yields have played in improving access to liquidity. We have a slight preference for European high yield given wider spreads in reaction to French political concerns. Within commodities, we have a moderately overweight view on oil given OPEC’s desire to keep the market tight and oil futures’ positive carry.
Turning to government bonds, slowing growth, declining inflation, and eventual central-bank easing underpin our moderately long duration stance across developed market regions. This view is challenged somewhat in Japan, where the Bank of Japan (BOJ) seems out of sync with inflation data, especially as the yen sinks to new lows, but we think the central bank will remain patient given weaker growth data.
Equities: Still positive, but broader would be better
We maintain a moderately overweight view on global equities. While economic growth momentum has slowed in the US, global activity continues to improve and the rate outlook in major markets is more realistic. Meanwhile, global earnings revisions continue to inflect positively and we expect earnings growth, rather than valuation expansion, to drive returns over the next 12 months. We also expect earnings growth to be more broad-based than it has been recently in the narrow market driven by mega-cap tech stocks. On the negative side, the resumption of mega-cap outperformance and the narrowing market advance in the latter half of the second quarter is a source of concern. The recent softness in growth data in the US and the flare-up in eurozone political risk have probably compounded market concentration dynamics. We would likely turn more positive on global equities if we saw signs that the equity rally was broadening out or if valuations cheapened in response to political flareups or weaker economic data.
We have reduced our view on Japan to neutral. We first moved to an overweight view on the country in November 2022, based on strong evidence of a macro regime shift and improvements in corporate governance. The push for better corporate governance, returns to activism, and rising margins have been helpful, and our view is that Japanese equities can continue to re-rate over the medium term and reduce the margin/ROE gap versus other markets. However, we are less bullish on macro conditions in the short term. Our outlook on inflation and rates is above consensus and we believe the BOJ is behind the curve on policy settings and risks losing credibility. While the BOJ has (seemingly) intervened as yen depreciation has intensified, this has provided only temporary support and more monetary policy action will likely be needed to stabilize the currency. All of this raises the potential for higher macro volatility or uncertainty in the short term, which means the overall risk/reward skew is less positive than a few months ago. The caveat to this view is that Japanese equities’ relative performance has become less tied to moves in the yen as companies have increasingly diversified their production abroad through subsidiaries.
We have raised our view on China and emerging markets broadly to neutral, thanks in part to the beginning of a rate-cutting cycle, albeit one that is likely to be shallow. We are also less willing to maintain an underweight view on China given cheap valuations, which recently drove a sharp rally. At the same time, structural headwinds and the lack of policy traction (Figure 1) keep us on the sidelines and reluctant to engage positively.
Figure 1
We were turning more positive on Europe given evidence of improvement in earnings and market breadth, but the resumption of political uncertainty has given us pause and we maintain our neutral regional view. Still, valuations are compressed relative to global equities, and the discount is even more pronounced in the UK, where underperformance has been driven by weakness in both relative earnings and sentiment.
In the US, we have also turned neutral. We think earnings will likely broaden out with little or no expected valuation expansion, and with large-cap tech likely to normalize as other sectors catch up (Figure 2).
Figure 2
Within sectors, we have an overweight view on financials, utilities, and consumer discretionary, and an underweight view on materials, staples, and communications. We maintain our neutral view on information technology.
Government bonds: Multiple themes acting on rates
Disparate factors popped up over the second quarter to drive moves in government bonds in developed markets. In the US and Germany, central bank easing is on the horizon and bond yields have rallied. Both of those government bond markets got a boost from their safe-haven status relative to France, where the spread to Germany rose in response to the political shift to the far right. Other “weak links” in southern Europe also saw spreads rise. In Japan, yields moved higher as the BOJ’s measured policy appeared out of sync with rising inflation and a weak yen.
We have moved from a neutral view to a moderately overweight view on duration because we have higher conviction that central bank easing will be the primary driver of rates over our 12-month horizon. In the US, we’ve seen more evidence that growth is softening (albeit from strong levels), including in manufacturing, consumption, and employment, and that inflation is decelerating. We think this is paving the path for the Fed to cut rates at least once this year following the ECB’s first rate cut in June. We also think the BOJ will remain patient given the recent negative GDP print and we would note that the high carry makes shorting Japan duration expensive.
The big question is on term premia and the extent to which France’s deficit concerns could ensnare a wider set of countries with similar issues. As of this writing, prior to the French Parliament elections, we think a French/German premium will persist but could widen further with a far-left majority and their even more ambitious spending plans. The US could face its own debt problems, of course, given that both presidential candidates share a predilection to spend beyond their means. However, the US dollar’s reserve status is likely to tip flows toward US Treasuries in a eurozone crisis scenario. Our view is that the environment is ripe for disruption but that markets will force politicians away from extreme policies. Either way, we expect higher rate volatility to persist and think investors need to be quite tactical to capture opportunities.
Credit: Still attractive despite tight spreads
With economic growth remaining solid, inflation receding, interest-rate cuts around the corner, default rates declining, and all-in yields twice as high as they were in 2021, credit looks attractive and we maintain our moderately overweight view. Tight credit spreads give us pause, but with strong demand for bonds and weak supply, we believe credit is an attractive place to generate income with limited potential for spread widening.
We are still observing moderate distress in issuers at the lower end of the quality spectrum, indicating that the “higher for longer” rate regime is creating headwinds for some companies. But with rate cuts already arriving in some regions and imminent in others, we believe relief will be provided to some of the riskiest names.
Technical supply and demand dynamics should be a positive driver of price support. Demand for corporate bonds has been very strong, as investors seek to lock in attractive yields ahead of a rate-cutting cycle. But the size of the high-yield market (the supply of bonds available to and held by investors) has been shrinking as many companies graduate back to investment grade after being downgraded in recent years. Strong company balance sheets, robust refinancing year to date, and a limited M&A pipeline suggest supply may continue to be overwhelmed by demand going forward (Figure 3).
Figure 3
We have initiated a preference for high-yield credit over investment-grade credit by moving our view on the latter from moderately overweight to neutral. We had previously seen investment-grade credit as a good place to generate carry, with some potential for spread tightening. Much of this spread tightening played out in the first two months of the second quarter, which caused us to moderate our view. Since then, we have seen significant volatility in the European investment-grade market, which has a large proportion of banks — potential targets of tax-raising measures that could be enacted by a newly elected government in France. We view this elevated political uncertainty as another reason to focus on higher-yielding parts of the credit markets.
Regionally, we have a slight preference for European high yield, funded from emerging market high yield. On valuation, Europe is where there is still a bit of a premium left and potential for some tightening in spreads. We are also turning more constructive on the European macro outlook, where momentum is improving and the central bank has already delivered a rate cut. We continue to monitor political developments in France (20% of the European high-yield market), which have caused spread widening in recent weeks, but we see these as an opportunity to add risk. In emerging markets, growth remains weak while many lower-rated idiosyncratic stories have played out, sometimes resulting in their spreads over-tightening relative to their fundamentals. Flows also remain lackluster.
Commodities: A stronger view fueled by oil
We have moved from a neutral view on commodities to a moderately overweight view, driven by an upgrade to oil. Oil looks fairly valued, with prices in the mid US$80s. However, we think a positive roll yield, which reflects the lower cost of longer-dated futures, warrants a more constructive stance.
We believe geopolitical risk in the Middle East limits downside to the oil price, and with supportive growth dynamics globally and a tight supply, the oil price is likely to remain range-bound at current levels. As a result, we believe that carry will primarily drive returns this year with some potential for capital gains if demand is stronger than expected or OPEC+ pricing power comes back into play.
Gold has been a strong performer in recent months, and we see limited further price appreciation from here as well as a negative outlook for carry, leaving us on the sidelines. Investors and central banks have been building gold allocations this year after weak sentiment in 2023, but with heightened geopolitical risks largely priced in, we think a lot of the positive case has already played out. We are waiting to see whether surging demand from retail investors in China will continue and whether central bank buying can further support prices.
Risks
Downside risks to our views include a reacceleration or spike in core inflation, leading central banks to push back against aggressive rate-cut expectations or even to resume hiking. In addition, our expectation of more broad-based gains in equities could be undermined by sharp upward momentum in one or more mega-cap stocks. Finally, geopolitical issues will bear watching, including the potential for election-year turmoil in the US and Europe and a broader conflict in the Middle East.
Upside risks to our views include a scenario where growth is more widespread globally and disinflation resumes, allowing central banks — and particularly the Fed — to cut rates faster than currently priced in by markets. We could also see a second-quarter earnings surprise on the upside, with a better earnings impulse outside of mega-cap tech stocks, and/or positive rotation in the market and better breadth than we expect. Additional upside risks include a resolution to the Middle East conflict and a balanced coalition emerging from the French election.
Investment implications
Consider sticking with global equity exposure — Growth and inflation are moderating from strong levels and central banks will eventually cut rates. We think allocators should keep a risk-on tilt despite expensive valuations and political noise, as we expect positive fundamentals to support earnings.
Anticipate broadening in the equity rally — We no longer have a regional equity bias and think gains could accrue to developed and emerging markets. We also see the earnings trajectory improving for areas outside of the mega-cap tech stocks, which could benefit some that have lagged, including value and small cap. Among sectors, we favor financials, utilities, and consumer discretionary over materials, staples, and communications, and we have a neutral view on information technology.
Consider overweighting duration and credit — Most central banks have pivoted to rate-cutting mode, so we see scope for lower yields across regions. We continue to like credit spreads for the carry, strong supply/demand technicals, and declining default rate. We favor high yield over investment grade given the positive macro backdrop and superior carry.
Benign expectations could be disrupted — While our risk-on tilt is supported by fundamentals, we are wary of volatility stemming from politics in Europe and the US, in particular. Depending on developments, we are biased toward using cheaper valuations as an opportunity to add risk in equities given the positive earnings backdrop and more reliable mean reversion in credit spreads.
Monthly Market Review — October 2024
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Brett Hinds
Jameson Dunn