AFMC - Getting Granular In Our Strategic Views

2023-11-28 01:30:00 ET

Summary

• We turn more positive on short- to medium-term developed market (DM) sovereign bonds in our latest strategic update. We trim DM stocks to neutral.
• Ten-year U.S. Treasury yields steadied after their drop from 16-year highs. We think yields will stay volatile but ultimately resume their climb in the long term.
• U.S. PCE inflation data out this week should gauge if price pressures are cooling further. We don’t see inflation coming down to the Fed's 2% target long term.

Transcript

Elevated levels of bond volatility are evidence of the new macro and market regime in action, and confirm the benefits of being agile with our strategic views of five years or longer.

We upgrade sovereign bonds in developed markets (DMs) to neutral, but this masks two stories - we stay underweight long-term bonds but turn overweight short- and mid-dated bonds. We also trim our preference for inflation-linked bonds, though this remains our largest overweight, and cut DM stocks to neutral.

Here’s why:

1) Yields to rise further

Our 3 1/2-year underweight to all DM government bonds is over, as market yields have risen in line with our positioning. At an aggregate level, we have turned neutral, but this is driven by a preference for short- and mid-maturity bonds - and what’s more noteworthy is what we didn’t shift. We remain underweight long-term bonds.

Why?

We think long-term yields will resume their climb as investors demand more term premium - compensation, for the risk of holding long-term bonds.

2) Higher inflation for longer

We believe higher inflation, plus greater fiscal- and climate-related spending likely mean the level of policy rates will be materially higher than before the pandemic.

Our updated view of higher neutral rates in the long term prompts a reassessment of equity valuations. Our strategic overweight to DM stocks - which we’ve held since the before end of Western lockdowns - is now trimmed to neutral. Long-term stock valuations look about fair to us, rather than warranting a higher allocation than usual. Though even with the downgrade to neutral, U.S. stocks remains our largest portfolio allocation.

We think the new volatile economic regime calls for more nimble and dynamic strategic views.

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We think granularity is key as government bond yields hit multi-year highs. We turn more positive on short- and medium-term DM bonds as we factor in high interest rates for longer in our strategic views of five years and over. We stay underweight long-term bonds, leaving us neutral DM bonds overall in our latest quarterly update. We like inflation-linked bonds and cut DM stocks to neutral on valuations. We remain underweight credit, preferring income in private markets.

Riskier long-term bonds

Forward-looking estimates may not come to pass . Notes: The chart shows the historical and estimated term premium ranges. The range captures three regions: U.S., Germany and UK. Term premium is defined as the compensation investors demand for the risk of holding long-term bonds. Our historical estimates of term premium are based on the Adrian, Crump and Moench (2013) “ACM” model, described in detail here: Our estimated range represents a five-year view, from 2023 through 2028.

We had been underweight DM government bonds since March 2020 as we expected yields to rise. We gradually trimmed the underweight as our view played out, increasingly preferring shorter-dated bonds. Now, with yields even higher, we explicitly carve out an overweight on DM short- and medium-term government bonds. We stay underweight long-term bonds as we see room for long-term yields to climb again. Why? Investors will demand more term premium, or compensation for the risk of holding these bonds across DMs, in our view. See the chart. This is due to more uncertain and volatile inflation spurring heightened bond market volatility. We also see weaker demand for bonds amid rising debt levels. Central banks are no longer reinvesting the proceeds of maturing bonds as part of quantitative tightening, and investors are struggling to digest a flood of new bonds.

The path to higher long-term yields is unlikely to be straight in the next five years. Indeed, we recently went neutral long-term Treasuries from a tactical, six- to 12-month view because we see more even odds of yields swinging in either direction. Inflation-linked bonds remain our highest-conviction overweight on the strategic horizon. Sure, inflation is falling in the near term as pandemic-era mismatches unwind, with consumer spending shifting back to services from goods. But in the long run, we see inflation well above 2% central bank policy targets. The reasons are big structural shifts constraining supply: slowing labor force growth, geopolitical fragmentation and the low-carbon transition. That’s why we see central banks keeping interest rates high for longer. Our updated strategic views bake in the impact of this.

Staying nimble and selective

We also turn neutral DM equities, with U.S. stocks remaining our largest portfolio allocation. We had been overweight since the end of Western pandemic lockdowns due to attractive valuations. Bond and stock markets have been moving toward our view of high-for-longer rates in fits and starts, and long-term valuations for stocks now look about fair to us. This is why we have turned neutral on the broad asset class - and look for opportunities within. The new regime has created uncertainty, resulting in greater dispersion of sector and individual security returns. How to capture these potential opportunities to generate above-benchmark returns? Nimble portfolios, getting granular and investment skill are part of the answer, we think.

These changes demonstrate why we think it’s important to be agile with strategic views. This new, more volatile regime means the relative attraction of different assets is shifting faster than we have been used to for a generation. Credit is a case in point. Just a year ago, we were overweight investment-grade credit because spreads looked attractive versus our long-run expectations. Then spreads tightened materially, and we turned underweight as we expect them to widen in the long run. Higher-for-longer rates will likely eat into corporate margins and earnings, in our view, especially as companies refinance debt. We see private credit lenders benefitting from refinancing activity as banks curb lending due to high rates reshaping the financial industry. That said, private markets are complex and not suitable for all investors. And private credit is not immune to the tough economic backdrop, but we think current yields compensate investors for the risks.

Bottom line

High rates are a core tenet of the new regime. We carve out a strategic overweight on shorter-term DM bonds and stick to our preference for inflation-linked bonds. We go neutral DM stocks but see granular opportunities.

Market backdrop

The S&P 500 hit a four-month high, taking its gains to about 11% from the October lows on a holiday-shortened trading week. The tech-heavy Nasdaq 100 hit its highest level since January 2022. Ten-year U.S. Treasury yields inched up back toward 4.5% but are still down about 50 basis points from their October peak. We think yields will stay volatile but resume their march as investors start to demand more term premium - a key part of our view on both tactical and strategic horizons.

We are monitoring U.S. PCE inflation data - the Fed’s preferred measure of inflation - due this week to gauge if inflation is on track to fall to 2%. We think U.S. inflation will near the Fed’s 2% policy target in the second half of 2024 but will not stay there long term. We think euro area inflation will also head back to target next year as economic activity stagnates.

This post originally appeared on the iShares Market Insights.

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