Our View in October
Sometimes the world of financial markets can be so simple. When interest rates rise, equity markets fall. When interest rates fall, equity markets rise. But there has been some nervousness behind this pattern recently. Against this backdrop we confirm our cautious portfolio stance.
Sometimes things move fast. Yields on 10-year US government bonds suddenly pushed towards the 5% mark at the beginning of October. Four weeks earlier they were just over 4% and earlier this year they were hovering around 3.5%. The recent surge was not due to rising inflation expectations, but to higher real interest rates reflecting the recent string of robust economic data in the US.
However, the 5% mark has not (yet) been breached. After the surprise attack on Israel by the radical Islamic group Hamas, interest rates fell again. It is difficult to pin down exactly whether this was due to a safe-haven demand for US government bonds or to dovish comments by Fed officials. What is clear, however, is that equity markets made up some lost ground.
It is common knowledge that no one cannot predict exactly where interest rates will go in the coming hours, days or weeks. However, the recent twist and turns show that markets are responsive and at times even nervous. This pattern coupled with the renewed uncertainty in the Middle East conflict, argues for a cautious portfolio stance. We have therefore decided to maintain our underweight in equities.
- Defensive orientation of the portfolio
- Yield advantage of emerging market bonds over government bonds from Europe or the USA
- Convertible bonds with convexity again
- Increased nervousness in the markets
- New geopolitical uncertainties after the attacks on Israel
- Recession risks remain despite robust US economy
Stabilisation tendencies in manufacturing
Looking at the development of key leading economic indicators, there have recently been signs of stabilisation in the manufacturing sector — at a low level though. There seems to be no further drop in industrial activity as there is a high need for investment spending, the keywords being "digitisation" and "decarbonisation". Investments in these areas are subsidised in the USA and Europe with large-scale government support programmes. These programmes are likely to have contributed to the recent stabilisation in the manufacturing sector. However, private consumption is still struggling worldwide. The high inflation rates have caused to a decline in real wages. Overall, the economic outlook remains negative. Even though the US economy is still performing better than expected, we still expect a recession.
- Manufacturing sector shows signs of stabilisation at a low level
- In the US the recession is being delayed further
- The US economy is likely to have grown strongly in the third quarter
- The Eurozone is struggling as the previously robust southern European countries are also coming under pressure
- Despite a somewhat improved economic outlook, the global economic environment remains difficult
Robust US economy causes yields to rise
Treasury bonds have suffered recently. Conversely, yields rose to new highs in the current cycle of interest rate hikes. This was not at all driven by rising inflation expectations but by the resilient US economy. Despite the Fed's interest rate hikes, the US economy has so far shown no clear signs of fatigue. This supports the scenario of a soft economic landing. If that were the case, interest rates would remain at the high levels for a longer period of time. However, we doubt that this will actually happen. The full effects of the interest rate hikes are yet to impact the economy on both sides of the Atlantic. We therefore continue to expect a noticeable economic slowdown and a subsequent environment of falling yields.
- A noticeable economic slowdown would cause government bond prices to rise
- We see the record-high forward sales of US government bonds as a contrarian indicator, which argues for falling yields
- Fading recession risks could push yields further up at the long end of the yield curve
- The Fed could raise interest rates even more due to the good state of the labour market
- Credit rating downgrades may briefly come to the forefront of investors' minds
High confidence in emerging market bonds
Yields on emerging market bonds have also risen recently. However, this was not due to higher risk premiums, but rather to the general market development. Yields on US and European government bonds have also climbed. The development is remarkable, because in the Eurozone the spreads of Southern European government bonds have risen compared to their German counterparts. For instance, Italy and Greece were valued lower due to higher credit risks, whereas this was not the case for emerging market bonds. This underscores the quality of emerging market debt. In any case, we feel confirmed in our positive assessment of this market segment and maintain our overweight.
- Higher yields compared to government bonds in the US and the Eurozone
- Major emerging market issuers have become more economically and financially stable
- In the event of financial market stress, risk premiums could rise compared to developed market bonds
- Defaults in selected countries could put broad-based pressure on emerging market bonds
The fantasy is gone
Since July global equity markets have been in an environment influenced mainly by interest rates. The US leading index S&P 500 has even trended downwards after a strong first half of the year, testing supports and closing a quarter with losses for the first time since 2022. Interest rates were the main driver after the Fed signalled that rates will remain high for longer. Although this had been expected for some time, it probably took this news for equity markets to react. As a result, the US markets were once again almost 100% correlated with interest rate developments. Added to this is a deteriorating economic environment. This combination is particularly challenging for valuations, which remain elevated despite recession risks. In the current environment we see no strong driver for further price fantasies; only technical indicators could lead to a rebound in stock markets.
- Positive earnings growth expected in the USA in the third quarter
- End of interest rate hikes approaching or already reached
- Leading indicators continue to point to a recession — not reflected in stock market prices
- China's economy has not yet managed recovery, which affects European equities
When will China recover?
While some emerging markets, such as Taiwan and Brazil, held up well for a long time this year, the broad emerging market index suffered disproportionately. This was not least due to China. The government in Beijing has so far refrained from adopting significant fiscal measures to support the economy. As a result, the country is not only suffering from weak growth, but foreign investors in particular are withdrawing their funds. The measures adopted so far also did not contribute to a change in perception. Therefore, the MSCI China has been in a clear downward trend since January and has lost more than 20 % from its peak this year. If confidence in the government and economy does not return, the market is not expected to turn around either. This will weigh on the broad emerging market index.
- Low valuation of the Chinese market in historical comparison
- Some regions held up better than markets in advanced economies
- Low confidence in index heavyweight China
- More measures are needed to boost the Chinese economy
- No complete decoupling from the development in advanced economies
Convertible bonds again with convexity
One of the most important arguments for convertible bonds is their convexity. This means that, as a rule of thumb, they participate to two-thirds in rising stock markets, but only to one-third in falling ones. Last year, however, they lost practically the same amount as equities, at minus 19 %. That was because bonds suffered record losses at the same time. This is unusual because they usually serve as a safe haven in times of weak stock markets. In the meantime, yields on bonds have increased significantly and their interest rate risk has decreased. Convertible bonds therefore benefit even when equity markets trend sideways. We expect that the "bond floor" to work again. Especially for defensive investors, convertible bonds thus offer a less risky alternative to equities.
- Convertible bonds with positive coupons again
- Convexity restored
- Compared to equities they offer partial insurance again
- Only hedged convertible bond funds offer protection against currency risks
- In case of a recession, weaker borrowers are likely to enter the convertible bond market
- A risk factor for the bond floor would be a resurgence of inflation
EUR/USD in a sideways movement
The European Central Bank (ECB) has reached its interest rate peak. The ECB did not formulate this so openly, but the coded choice of words suggests it. The economic risks are coming to the fore. But it is by no means the case that interest rate cuts are now on the immediate agenda. The ECB's motto is "higher for a longer period". This means that the potential for monetary policy surprises on the euro side has been exhausted. For this very reason, we are adjusting our outlook and now expect a sideways movement of the EUR/USD currency pair between 1.05 and 1.12. From a market perspective, the positioning in future markets has become less extreme. Previously, the positioning served as a contrarian indicator for a euro appreciation, which worked quite well - after all, the euro was still trading at levels of 0.95 against the dollar about a year ago.
- The Swiss franc remains well supported, also thanks to the SNB's foreign exchange interventions
- The British pound has recently benefited from higher key interest rates and the lower interest rate differential against the dollar
- The euro no longer receives support from monetary policy
- Appreciation potential of emerging market currencies remains limited in view of geopolitical risks
SNB and Bank of England surprise markets
The September meetings of the central banks offered a lot to talk about. As expected, the Fed left the fed funds target rate unchanged, but stuck to its hawkish tone and did not rule out another rate hike in November. Both the Swiss National Bank (SNB) and the Bank of England, on the other hand, caused a stir: Both left their key interest rates unchanged and decided to continue to wait and see for the time being. In contrast, the European Central Bank (ECB) acted almost according to schedule: It decided to raise interest rates by another 25 basis points. However, the ECB was cagey about the further course of monetary policy. Since inflation rates will fall noticeably in the coming months and the central bank will base its monetary policy more on actual data than in the past, there should be no further interest rate hike.
- The Fed has reached the interest rate peak
- The SNB has probably reached the interest rate peak as well
- The ECB is in a dilemma in view of weak economic development
- The restrictive monetary policy increases the potential for financial market stress
Dr. Felix Brill, Dr. Thomas Gitzel, Dominik Pross, Bernhard Allgäuer, Jérôme Mäser
VP Bank AG
CIO Office
Aeulestrasse 6, 9490 Vaduz, Liechtenstein
T +423 235 63 99; cio-office@vpbank.com
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