EWJV - Finding New Opportunities As Q4 Starts

2023-10-02 11:40:00 ET

Summary

• Markets are adjusting to the new, more volatile regime. We see opportunities in the UK and euro area bond repricing, and still prefer Japanese equities.
• U.S. stocks dipped last week, and 10-year Treasury yields fell sharply from the week’s highs. A further drop in goods prices helped cool August PCE inflation.
• A U.S. government shutdown has been averted for now. Yet, the risk of one highlights ongoing U.S. fiscal challenges.

Transcript

Markets are adjusting to the new, more volatile regime. The recent spike in 10-year Treasury yields and the sharp pullback in equites is evidence of that, in our view.

As markets adjust, we find different yet abundant investment opportunities. To find them, we must first acknowledge that not all yield rises have the same investment implications.

1) Government bond pricing shifts

This year’s yield spikes have been mostly from the market repricing its policy rate expectations.

We think that is now largely done, but we expect the compensation investors demand for the risk of holding long-term bonds to rise further. That will push yields higher as markets price in factors such as persistent inflation and high debt loads. As a result, we stay underweight long-term bonds.

2) A more nuanced equity story

This term repricing, in and of itself, isn’t necessarily an issue for equities.

We stay underweight broad U.S. and European equities in the short run, as stocks don’t fully reflect stagnant growth.

The macroeconomy may not be your friend, but opportunities are plentiful.

Within fixed income, we like UK gilts and European bonds given major market repricing. We stick with short-term U.S. Treasuries. Repricing largely reflects a view that policy rates will be structurally higher. Within equities, it’s all about being selective. We see opportunities in artificial intelligence and Japan.

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Markets are adjusting to the new regime of greater volatility and higher interest rates. This is starting to create some opportunities, in our view. Yields in long-term government bonds have surged, making European bonds look more attractive to us. Yet, broad developed market ((DM)) equities still don’t fully reflect the new rate environment or unfriendly macro backdrop, even with their retreat. We stay selective in stocks, still preferring Japan and mega forces like artificial intelligence.

Adjusting to new regime

Past performance is not a reliable indicator of current or future results. Indexes are unmanaged and do not account for fees. It is not possible to invest directly in an index. Notes: The chart shows total returns for the S&P 500, S&P 500 equal-weighted index and Bloomberg U.S. Government 10 year+ index.

Ten-year U.S. Treasury yields have jumped to 16-year highs and long-term Treasury returns have slid (pink line in chart). The sharp rise in yields since the summer sparked a pullback in equities - with the equal-weighted S&P 500 (yellow line) that adjusts for the outsized impact of mega-cap companies erasing almost all its year-to-date gains. The rise in yields so far has largely been about markets realizing that central banks are poised to keep rates higher for longer, in our view. This adjustment to higher yields is bad for fixed income returns. But not all yield rises are created equal. The repricing of expected policy rates has largely played out, yet the compensation investors demand for the risk of holding long-term bonds - or term premium - has only risen a fraction of the amount we expect. We expect an increase in term premium to drive the next leg of higher yields. That is bad for bonds but not necessarily bad news for equities.

Concerns over U.S. debt levels and large Treasury issuance have prompted investors to demand more compensation for the risk of holding long-term bonds, driving long-term yields higher. We expect a further rise in such term premium and long-term yields due to those factors, plus persistent inflation and higher-for-longer rates. With long-term yields at multi-year highs, bonds offer more income. Yet, a march higher in yields can wipe that out: A roughly 0.5-percentage point rise in yields could drag on valuations enough to erase a full year of income for a 10-year duration bond. And such moves can happen quickly in this new macro regime. We stay underweight long-term bonds in our tactical and strategic views in Q4. The threat of a U.S. government shutdown - if pushed back for now - also highlights the long-term fiscal challenges the U.S. faces. If Congress eventually fails to provide funding for the new fiscal year, we expect a limited macro and market impact - similar to past shutdowns - because only a small part of the economy is directly impacted.

Eyeing opportunities

The difficult macro environment keeps us underweight the broad U.S. equity market on a tactical horizon of six to 12 months: stocks don’t fully reflect higher-for-longer rates and the ongoing activity stagnation we expect. With the Q3 earnings season starting soon, analysts now see a mild contraction in broader Q3 earnings after having eyed growth earlier in the year, LSEG data show. We are getting closer to turning more positive on stocks given the recent retreat - but we’re not quite there yet.

As markets play catch-up with the new regime and its implications, we take advantage of relative disconnects in market pricing and find new opportunities based on what’s in the price. We recently went overweight long-term euro area government bonds and UK gilts on higher yields, and in our view policy rates will be cut more than the market is pricing. Higher yields also underpin our overweights to short-term Treasuries and EM hard currency debt - generally issued in U.S. dollars.

We center our outlook on mega forces, or structural forces that can drive returns now and in the future. We get granular within asset classes to find sectors and regions that can thrive even as growth broadly stagnates in coming quarters. We went overweight Japanese stocks last month on the potential for earnings to beat expectations and ongoing shareholder-friendly reforms. We’re also neutral on UK and EM stocks. Our overweight to the digital disruption and artificial intelligence ((AI)) mega force in DM stocks taps into markets favoring companies generating ample profits over any hit from higher-for-longer rates.

Bottom line

We find new opportunities in Q4 via pricing disconnects and mega forces. Read our updated global outlook.

Market backdrop

U.S. stocks dipped last week, while the 10-year U.S. Treasury hit a 16-year high of 4.69% before retreating sharply on Friday. Euro area bond yields hit multi-year highs last week as markets priced in policy rates staying higher for longer, with fewer rate cuts. And Italian government bond spreads widened on a wider-than-expected government budget deficit forecast. Meanwhile, U.S. core PCE inflation rose less than expected in August as goods prices extended their drop.

With a U.S. government shutdown avoided for now, U.S. payrolls data for September is in focus this week. Pandemic-era mismatches in supply are unwinding - helping to cool inflation. Yet, we think a shrinking workforce as the population ages means the economy will only be able to sustain a fraction of recent job growth to avoid resurgent inflationary pressures.

This post originally appeared on the iShares Market Insights.

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