House View Q4 2024: Shifting gears

01/10/2024

Our view of global markets

Watershed moment

The fact that the interest rate cut by the US Federal Reserve in September was anticipated makes it no less of a watershed moment for markets. While the opportunity set for investors may not change overnight, we think it marks the beginning of the end of a period where technology stocks and cash (or cash-like instruments) have been the only game in town.
In our view, a soft landing continues to be the most likely outcome for the US economy. The future trajectory of interest rates – including the speed of cuts and the new neutral rate – remains in flux. But we think markets expect more rate cuts than a soft-landing outcome would indicate, and a repricing of expectations could be one source of coming volatility.
Overall, conditions should be positive for both bonds and equities, with a particular focus on developed-market equities, investment grade corporate bonds and sovereign bonds.
We know from the brief turmoil in markets in August that every data point is pored over in the current uncertain environment: investors will want to consider an active approach to emerging opportunities.
Staying vigilant, this is the time to consider positioning for an era where risk may be priced differently – and investors can consider more options – than in the recent past.

Chart of the quarter

Rate cut expectations: too aggressive?
Markets expect an aggregate of 135 bps of global cuts over the next year, compared with only 75 bps at the end of June.¹ A significant chunk is expected in the US, more than would be anticipated in a soft-landing scenario. Therefore, we think a repricing of expectations may follow, sparking volatility.

Multiple factors driving volatility

Overall, we are positive about the months ahead, while recognising that we are entering a period of below-potential growth where downside risks will naturally increase. While not our base-case scenario, the risk of a US recession has risen. The challenge is that there is often little forward visibility of a downturn: labour market data tends not to trough until a recession has already arrived.
Geopolitics are set to be a continuing source of volatility as events unfold in the Middle East and Ukraine, risking another potential surge in energy prices.
The US election looms large, and the policies of the winner are likely to deliver a lasting market impact. We also see risks in Europe, where France and Germany are absorbed by domestic issues while growth and financial stability are vulnerable. There is the danger of broader euro zone instability, with implications for bond markets.
Growth estimates for corporate earnings are relatively concentrated, and any risk of disappointment could also unsettle investors.
In summary, after a period of relatively becalmed markets – notwithstanding the odd pick-up in volatility – prepare for a potential return of structural volatility in 2025.

Consider the following:

Equities: Expect quality and growth to outperform amid lower rates; we add selectively to defensive sectors on US election volatility; consider water as a defensive play.
Asia: Look at India where the growth potential may be worth the valuation premium; China could be a contrarian market benefiting from property market stabilisation; consider Japan again after drawdown in August.
Fixed income: Consider long Gilts versus a basket of G4 markets; we prefer risk in curve and long duration in select markets and we see attractive relative value opportunities in sovereign yield curves. In investment grade, we favour financials on a relative-value basis, and emerging market debt for some positive fundamental stories despite sensitivity to US Treasuries.

See below for more details of our asset class convictions.

Structurally higher volatility in the months to come may give investors pause. But with returns on cash falling – and a broader set of opportunities coming into play – we think investors should reconsider their positioning.

Asset class convictions

Equities

Fixed income

Multi asset

Focus on quality and growth

While global economic growth is decelerating, this should not necessarily be read as a bearish signal for equity markets. As inflation and rates also come down, this glide path is likely to be positive for quality and growth and we expect these styles to outperform in the coming months. Indeed, the fortunes of the global economy are highly dependent on whether this glide path of a balance between rates, growth and prices is achieved – yet, at present, all signs point towards a favourable outcome in this respect.

The final part of the year will probably see some volatility – not least given November’s US elections – so looking selectively to some defensive options to make sure portfolios are as balanced as possible should be a sensible approach. UK equities look attractively valued in our view and should benefit from the impact of lower rates and political stability. M&A has actually been quite active in the UK given low valuations.

Other areas such as small caps and tech should do well in an environment of lower rates and moderate growth. Stocks linked to the water theme also currently look like good defensive opportunities as they are not dependent on any specific policy programme.

Still favour Asia

Overall, we continue to favour Asia as a region. Given the recent strong drawdown in Japan – the second biggest in history – and ongoing structural reforms, Japan equities are favoured at the moment. We are also seeing positive earnings revisions, buybacks and rising dividends.

In China, the property situation seems to have stabilised, which may well act as a catalyst for stocks, many of which are currently very attractively priced. Geopolitics, of course, remains a risk here, with any potential expansion of existing trade frictions likely to dampen sentiment. We would expect a more favourable environment in Q4 2024 for Chinese equity markets.

Turning to India, while there is certainly a valuation premium, this is likely to be more than compensated for by strong growth. Very strong fundamentals, most notably India’s favourable demographics – a large working-age population with a median age of just 28 – point to a positive economic outlook in the coming years. For instance, the Indian consumer market alone is forecast to more than double in size by 2031.

Three reasons to like emerging market local currency bonds

Three factors underpin our positive view of emerging market local currency bonds. First, emerging market inflation has been falling at a faster pace than emerging market central banks have been delivering cuts. That means emerging market real yields are currently at multi-year highs, suggesting emerging market central banks have ample room to make further cuts. The start of the Fed’s rate cutting cycle should bring further momentum to rate cuts in emerging markets.

Second, the spread between local bond yields and US Treasuries has widened steadily over 2024, making for a compelling carry opportunity. Third, emerging markets growth looks resilient for this year and next and should easily exceed growth prospects in the developed world.

We foresee further downward moves in emerging market local currency bond yields in the coming months.

EM real rates are at multi-year highs, giving central banks ample room to cut policy rates

Source: Bloomberg, Allianz Global Investors, as of September 2024. Simple average for Policy Rate deflated by 12M CPI for the following countries: South Africa, Brazil, Mexico, Uruguay, Dominican Republic, India, Colombia, Romania, Hungary, Peru, Poland, Czech Republic, Chile, Indonesia, Malaysia, Thailand, China, and Turkey.

Focus on developed market sovereign bonds – particularly the UK

We are constructive on the outlook for sovereign bond returns, given the current global macro and policy backdrop. We favour a long interest rate duration stance in several markets and prefer to be positioned for steeper yield curves, especially in the US and euro zone.

Markets are beginning to pare back expectations for US growth, while European and Chinese growth remains lacklustre. Inflation pressures too are on an easing path, helped by sliding commodity and energy prices. We see opportunities surrounding a potential repricing in interest rate markets, particularly if the probability of a hard landing increases over the coming months and central banks front-load rate cuts. If inflation break-evens fall further as near-term inflation risks dissipate, we would also favour balancing our positioning by adding some inflation protection in portfolios.

We like UK Gilts on a relative value, cross-market basis against German Bunds. We believe that interest rate markets are insufficiently pricing Bank of England rate cuts over the next six to nine months in comparison to the ECB and Fed.

Equal-weight investments in the US stock market

The concentration in the US equity market is at its highest level since the 1970s, driven by the stellar performance of the Magnificent Seven. Concerns over their outsized influence make the equal-weighted approach compelling, offering diversification that reduces single-stock risks, as shown by Nvidia’s recent earnings reporting.

History shows that dominant companies rarely maintain leadership. Of the top 10 largest companies globally in 2010, only Apple and Microsoft remain. This is also substantiated by research indicating a long-term underperformance of the largest listed firms and supported by today’s valuation gap of 3x vs. 1.7x sales.

More tactically, our expected soft-landing scenario could broaden market participation as the earnings growth gap between the Magnificent Seven and the remaining 493 companies is expected to narrow. Investors have started to pay attention: since mid-July, the equal-weighted approach has outperformed after 18 months of lagging behind.

It is not without risks as the largest firms could continue to exceed the expectations of the market, though we believe the reduction of idiosyncratic risks, reasonable valuation, and expected earnings growth to outweigh these concerns.

Consider equities over high yield

We favour equity markets over high yield bonds in an environment where we are constructive about the overall risk outlook. It is true that US equities, mainly driven by growth stocks, appear quite rich. But given that we prefer value compared to growth and equal weighted vs market capitalisation weighted, broad equities in general and – European equities in particular – do not appear overly rich. In the US, we have seen that high valuations can last longer than anticipated. We think technical conditions are still supportive of equity markets and we see potential for further gains.

At first glance, the carry offered by high yield looks quite attractive, especially since the economic backdrop is not showing any red flags. But given current five-year spread duration, any sizeable market shock risks eroding carry opportunities.

While both US and European equities are still below their highs, US and European high yield investments have marked new highs since August. In summary, given the low spread level, we see less opportunity for a sustained performance boost in high yield compared to equities.

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