DFEV - Why The Structural Matters Now

2023-10-09 23:57:00 ET

Summary

• We see markets adjusting to the new regime. This is not a typical business cycle - structural mega forces are shaping the outlook now, in our view.
• The 10-year U.S. Treasury yield jumped to 16-year highs as markets eyed higher-for-longer interest rates. Stocks ended a volatile week little changed.
• The Middle East conflict is in focus. U.S. CPI data this week will help gauge how quickly supply mismatches are unwinding.

Transcript

The recent joint selloff in equities and bonds shows that markets are adjusting to this world of supply constraints and this new regime of greater macro uncertainty.

And it’s also really clear that this is not your typical business cycle. Cyclical forces are interacting with structural forces in a way that we haven’t seen before.

And structural forces are having an effect and an impact on the economy and on the markets right now - not just something that will happen in the future, but right now.

1) We’re tracking five mega forces

And we have identified five mega forces, structural forces that we call the mega forces, and they are, in no particular order:

1. AI
2. Geopolitical fragmentation
3. The transition to a low-carbon economy
4. Aging populations
5. The future of finance

2) Rate repricing and mega forces

And even rate repricing, the recent rate repricing can be viewed through the lens of mega forces as well as markets price in higher rates, higher r, and lower potential growth, lower g.

And what is also interesting is that in the face of very notable rate repricing, the Nasdaq that has a higher rate sensitivity compared to the broader U.S. equity market actually outperformed the U.S. equity market on a relative basis, and that is exactly the AI mega force at play.

So, when we think about adjusting to this new regime of markets shaped by these mega forces that we just talked about, there will more opportunities presenting themselves likely on a more granular level, on a sectoral level instead of broad brunt building blocks. And that is how we are thinking of our asset allocation as well.

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Market reset

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 two ends of the bars show the lowest and highest returns at any point in the last 12-months, and the dots represent current year-to-date returns in U.S. dollars. Developed market equities based on the MSCI World Index. Other indexes used are listed in the chart on page 2.

Developed market ((DM)) stocks have erased about half of this year’s gains - though tech has held up partly due to momentum behind the artificial intelligence ((AI)) mega force. See the chart. The 10-year U.S. Treasury total return is nearing a loss of about 4% this year, with capital losses wiping out the income it provides. And the risk it bears has been thrown into the spotlight this year: a full percentage-point climb in 2023 and double-digit basis point swings each day becoming routine. Surging long-term Treasury yields show markets are adjusting to a higher level tied to mega forces: looser U.S. fiscal policy, the big reallocation of resources in the low-carbon transition and geopolitical fragmentation rewiring supply chains. We see many DM economies on a structurally weaker growth trend due to mega forces such as aging populations. Long-term yields are more in line with our views, but we think equities still don’t fully reflect higher-for-longer policy rates.

Activity in the U.S. has stagnated for 18 months as the economy moves onto a lower growth path. Seemingly strong payroll gains last week might seem like good news. But companies were slow to rehire in the restart of activity following the pandemic - and they’re still catching up. We estimate that, without this catch-up effect, job gains would be slowing. We think focusing on monthly job creation also masks a broader trend since 2020: Overall employment growth has been modest, yet unemployment is lower. That shows labor supply has slowed as the population aged. We think the tight labor market reflects this supply constraint, not a strong economy.

Harnessing mega forces

That’s why it’s key to harness the sector and company impacts of these mega forces in this tricky macro environment. The key for us: Identify the catalysts that can supercharge them, see how they interact with each other and uncover the likely beneficiaries not yet priced in by markets. We saw such a catalyst in AI earlier this year when we went overweight on our tactical six- to 12-month horizon. Our work finds the value of AI patents from public companies has surged, and it could suggest they’re submitting higher-quality patents. This is not just about public markets: we find private markets make up a growing portion of firms filing for AI patents and may have more companies focused exclusively on AI.

We see other mega forces intersecting and creating big shifts in profitability across economies and sectors. We see potential across the energy system in the shift to a low-carbon economy, depending on the interplay of policy, tech, and consumer and investor preferences. Healthcare, real estate, leisure and companies with products and services for seniors may stand to benefit in DMs as people age, while emerging markets ((EM)) like India and Mexico benefit from younger populations. EM is also leading the way in digital payments in the future of finance. Some EMs could strike deals across divides in a fragmenting world and benefit from companies bringing production closer to home, while broader economic competition could spur global investment across tech, clean energy, infrastructure and defense. We also think a fast-changing U.S. financial landscape is poised to create opportunities in private credit as banks curb lending. U.S. regional banks have come under renewed pressure from surging yields just as Q3 earnings reporting season kicks off this week.

Bottom line

Mega forces are shaping the new regime with geopolitical fragmentation now in focus. Treasuries have served us well as yields rise. We stay underweight DM equities but lean into AI to harness mega forces, while the macro backdrop remains unfriendly for broad asset class exposures.

Market backdrop

The 10-year U.S. Treasury yield jumped to new 16-year highs last week, while U.S. stocks ended a volatile week little changed. We are seeing the new, volatile regime in action, with sharp intraday and weekly market moves. U.S. payrolls data showed a surprisingly strong number of jobs created in September. We think the economy can only sustain a fraction of recent job growth as the population ages - or it risks stoking further inflationary pressures.

We’re eyeing U.S. inflation and spending data this week to gauge if the drop in goods prices will keep leading inflation lower as consumer spending shifts back to services. We estimate about two-thirds of the spending shift has now unwound. Yet, population aging will likely keep the labor market tight, driving inflationary pressures and a rollercoaster ride in the data.

This post originally appeared on the iShares Market Insights.

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