KBND - Going Granular In DM Stocks

2023-11-06 14:05:00 ET

Summary

• Developed market (DM) central banks have signaled high-for-longer policy rates. We stay selective in DM equities and prefer international stocks.
• U.S. stocks bounced 6% last week as 10-year Treasury yields plummeted on the Fed's pause and slowing wage growth, underscoring the new regime's volatility.
• This week's slew of macro data will likely show muted economic activity in China on weak consumer spending and exports. We're neutral emerging stocks.

Transcript

It’s been a very heavy week in central banks, and as it becomes clear that we are probably at peak rates, sentiment is getting a bit of a boost from the recent correction.

I will make three observations.

1: Higher rates ((R)) and lower growth ((G))

Number one, the framing of the new regime of higher R and lower G is getting more recognized, and markets are pricing that in more. So first in rates and then to some extent in equities if you look at the recent correction, and also in private markets to some extent as well. So, markets are pricing in the new regime.

2) Being selective

Number two, well despite the correction and nervousness in markets earlier, we want to resist the temptation to buy the dip across the board indiscriminately, because if you look at the data, digging under the hood, yes consumers are holding up, but they are wearing down their pandemic savings.

If you look at manufacturing PMI in the U.S., in Europe, it’s clear that we are experiencing a manufacturing recession. If you look at company earnings, if you look at their guidance, they are missing clarity, so they are guiding next year lower. So, we continue to be selective in terms of where we deploy risk, focusing on quality companies and sectors and also companies and sectors that are still delivering and driving earnings, and tech here stands out.

3) Pricing in the new regime

Number three, we are selective more broadly to that extent the new regime is more priced in, which is why rates have priced that in more. We turned overweight UK and European government bonds. And two weeks ago, we closed our long-held underweight in U.S. duration, underweight to neutral.

But equities we are still quite selective based on valuation. And Japan, for example, yes it has outperformed so far this year, but rates are still lower in Japan, so equity risk premium on that basis is still very attractive. We upgraded it twice, and it is still a preferred country within developed markets at this juncture.

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Markets rallied last week from multi-month lows after central banks kept rates steady and signs emerged of slowing U.S. wage growth, highlighting the volatility of the new macro regime. What got lost in the shuffle: central banks have signaled policy rates are staying high for longer. As markets adjust, we find that granular opportunities abound. We stay selective in DM stocks and bonds, tapping markets like Japanese stocks on the back of corporate earnings and reforms.

Regional divergence

Notes: Each line in the chart shows the earnings yield - or the inverse of the price-to-earnings ratio - minus the yield for 10-year government bonds for the U.S., UK and Japan.

We see regional stock markets facing diverse policy, inflation and growth prospects - affecting corporate earnings. That variety is reflected in the wide dispersion in excess compensation investors receive for the risk of holding stocks over bonds - or earnings yield minus bond yield - in different DMs. That divergence creates opportunities to be selective, in our view. The excess yield is compressed in the U.S. (dark orange line). We remain underweight U.S. stocks - still our largest portfolio allocation - on a six-to-12-month tactical horizon. We get exposure to the tech sector, which has outperformed the broader U.S. stock market, through an overweight to the artificial intelligence ((AI)) theme in DM stocks. The compensation is higher for the UK (green line), but we see diminished growth prospects there. We’re neutral UK stocks. The excess yield is slightly higher for Japan (yellow line), where we are overweight.

Ten-year Treasury yields saw their largest weekly drop in a year last week. We went neutral long-term Treasuries last month because we saw equal odds of Treasury yields swinging in either direction after their surge to 16-year highs. That two-way volatility is playing out now in large daily moves - and yields are still sharply higher since the start of the year. U.S equities have bounced up after a stretch of losses - even when stripping out the impact of the largest public companies. Higher valuations have pinched the earnings yield gap over higher bond yields. Yet, U.S. corporate earnings growth has sputtered in the past year as economic activity has broadly slowed. We stay cautious on DM stocks. U.S. Q3 corporate earnings have slightly beat muted expectations on modest revenue growth, pointing to an expansion of profit margins. But we think higher interest rates and financing costs will crunch earnings and profit margins.

Other DMs

We assess what’s in the price for both stocks and bonds in other DM markets. We recently went overweight euro area government bonds and UK gilts to lock in higher yields as markets price in rates staying higher than even we expect. We stay underweight euro area stocks: even with attractive valuations versus U.S. stocks, expectations for high-single digit earnings growth over the next year look too rosy to us. Euro area corporate margins face pressure from higher rates and slower global growth. We upgraded UK stocks to neutral in July and stay there as attractive valuations better reflect the weak growth outlook and hit from rate hikes. Yet, we don’t see a catalyst for turning more positive.

We’re underweight Japanese government bonds. We see their yields rising further: the Bank of Japan took a step away from its ultra-loose monetary policy last week when it loosened the cap on 10-year yields even while reserving the option to intervene if yields rise too fast by making 1.0% the “reference rate.” We still see a supportive backdrop for Japanese corporate earnings and stocks, thanks to stronger growth and reduced policy uncertainty. We stay overweight after upgrading them from neutral in July. Corporate reforms, such as bigger share buybacks and dividends, are also shareholder-friendly.

Bottom line

Markets are starting to price in the volatile new regime of higher rates and lower long-term growth. We see greater dispersion - and opportunities - as a result. DM stocks are the major building block of portfolios. We get selective across regions based on valuations, earnings prospects and what’s in the price. We’re overweight short-term Treasuries and recently upgraded long-term bonds to neutral. We are also overweight euro area government bonds and UK gilts.

Market backdrop

U.S. stocks jumped 6% this week on the drop in long-term yields. Ten-year U.S. Treasury yields fell around 0.3 percentage points this week - the largest weekly drop in a year - and are nearly 0.5 percentage points below the 16-year high hit last month. We think these sharp yield swings reflect the more two-way risk for bonds as the Fed nears the peak in policy rates. While data revealing slowing wage growth is a step in the right direction, we don’t see rate cuts until later next year.

China takes center stage this week. A slew of macro data will help gauge how subdued activity remains. Two key challenges weigh on China’s economy: sluggish consumer spending and weak demand for its exports. Crucially, spending lags its pre-pandemic pace. We revised our 2023 growth expectations down to around 5% as a result.

This post originally appeared on the iShares Market Insights.

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