Following significant (and opposing) moves in fixed income (rising) and equity (falling) risk premia, bonds now offer a higher risk premium than equities for the first time since 2008.
Equities look vulnerable to us. Cracks are starting to appear in higher frequency labour market data. Leading economic indicators such as the senior loan officers and business surveys are pointing to weakness ahead in the US and Europe. Both forward valuations and beneath those, earnings expectations, are not consistent with weaker growth (and lower inflation).
Investment, in particular, should fall further in both the US and Europe. In the US, current levels are already suggest a meaningfully higher unemployment rate lies ahead.
With any prospect of a renewed overheating of the economy (in the US) firmly off the table and data starting to roll over, we would place even odds on recession or recession with inflation (‘stagflation) as the most likely macroeconomic outcomes over the next 6-12 months.
Overall, we see the current market and macroeconomic constellation as warranting caution – yet equity valuations are fuller that they were January, earnings estimates are broadly optimistic, and our equity market temperature framework is flashing red. Areas where we are cautiously positioned (Europe and the US) stand out here, with emerging markets, our key long, notably attractive.
Rates – An opportunity to add
Now that US 10-year Treasury yields have soared through 4% in just a few short trading days, we have begun to build long positions in US sovereign bonds (our view: favour) in active multi-asset portfolios, in addition to our exposure to long-dated US TIPS (Treasury Inflation-Protected Securities) which is our largest risk position.
Bonds have sold off on firmer (but lagging) data on the US housing and labour markets and concerns over more hawkish central bank action underscored by recent meeting minutes from the policymaking Federal Open Market Committee. A more hawkish Federal Reserve could see yields move to 4.25% or higher, levels at which we would be looking to add, all things being equal.
As data start rolling over, nominal 10-year yields could go to 3% or lower depending on the severity of the growth correction. At 4%, the diversification benefit from government bonds is also not to be scoffed at: investors last captured 4%+ yields in the period preceding the Great Financial Crisis.
On corporate bonds, meanwhile, we have seen a striking and indiscriminate tightening of credit spreads. While this could indicate that investors see the current macroeconomic environment as positive for carry trades, we are more selective.
We continue to see European investment-grade (IG) credit (our view: favour) as the most attractive position. It offers investors generous compensation for overly pessimistic expected default rates in an environment of strong, high-quality balance sheets.
At current spreads, European IG spreads compensate investors by more than average for the next highest credit rating – with e.g., AAA spreads offer an attractive spread ‘buffer ‘for AA credit risk. This is not the case in US IG bonds.
As said, our most significant risk is currently the overweight position in US TIPS, while our least risky position is euro IG credit (see table below).
Exploiting the gap between UK Gilts and Bunds
Amid sticky inflation, European bond yields have reached our 2.5% target and we have taken modest profits on our tactical short position in multi-asset portfolios that were established when yields on German government bonds (Bunds) were at 2.21%.
This has been replaced by a duration-neutral long position in 10-year UK Gilts (our view: favour) versus a short 10-year Bunds position, seeking to exploit the pricing asymmetry.
Gilt spreads are close to the highs of last September‘s ‘LDI crisis’ when hedging needs and margin calls triggered a vicious circle of bond selling that forced the Bank of England to step in as the buyer of last resort and restore stability. Concerns over the ability of the UK government of the time to ensure debt sustainability ‘broke’ the Gilt market.
We believe a lot of concerns over UK politics and the BoE are now baked into prices. European bonds, by contrast, are judged to reflect the ‘best case’. This relative trade also offers modest positive carry.
Recently, the ECB upgraded its inflation forecasts to levels that are still above its medium-term target of 2%, throughout the forecast horizon. Unit labour costs appear to be driving these changes, suggesting some stickiness in this outlook. Our macroeconomic team sees the ECB raising rates once more in July – to 3.75% – and then cutting rates from the first quarter of 2024.
Risk appetite at extreme levels
A broad appetite for risk would seem to us to be at odds with the cracks that are starting to appear in recent macroeconomic data such as US weekly jobless benefit claims (rising) and the senior loan officers and business surveys (indicating weakness in the pipeline in both the US and Europe). US investment levels are already consistent with meaningfully higher unemployment (see Exhibit 1).
Sources: BNP Paribas Asset Management, ASR and Macrobond; as of June 2023
In our view, investor risk appetite is now close to extreme risk-seeking territory. Risk premia for fixed income and equities have moved in opposite directions, leaving fixed income premia above those for equities. Notably, this has occurred for the first time since 2008 (see Exhibit 2).
Broadly speaking, we believe equity price-earnings valuations are full, 2024 earnings estimates are (overly) optimistic, and our equity market temperature gauge is flashing red. Areas where we are cautiously positioned – Europe and the US – stand out here.
We are struck by the gap between weakening US manufacturing sector survey data – which can be seen as a proxy for the wider economy – and recent equity market trends (see Exhibit 3).
Adding to our position in European banks
We added to our relative value position in European banks, expecting them to continue to outperform the broader European market. This view is based on
- Good expected earnings (after one of the best quarterly results ever)
- Strong net interest margins (which will be supportive for a few years)
- Rising returns on equity
- Profitability is at decade highs
- Operational and regulatory trends are positive
- Loan loss provisions have already been taken.
We see banks as semi-utilities that offer better prospective returns in a higher inflation world; 34% of the market cap is expected to be returned to shareholders this year in dividends and buybacks.
Valuations look attractive across a range of metrics (forward price-earnings ratio, dividend yield); they are at, if not through, multi-decade lows.
Asian equities – Taiwan, South Korea and Japan
The flatlining of Asian equity performance – our preferred long against a short in Europe – masks a wide dispersion, with stock markets in Taiwan and South Korea doing much better than China. Similar, but less, dispersion can be seen in the evolution of analyst estimates for calendar-year earnings per share: only South Korean EPS has shown a notable upturn.
Macroeconomic data in South Korea has improved, but large index components (Samsung and Hynix) have only partly re-rated. Taiwan by contrast has benefited from the media and market hubbub around artificial intelligence of recent months. Relative to the global tech sector and to the global semiconductor sector, the market is trading at a discount to its historical valuation.
Finally on Japan, where we have stayed neutral so far, data on real activity and inflation is improving and indicators on the important factory automation sector look to be troughing. Fund flows are returning, but remain well short of the levels of nearly a decade ago. Corporate reform and a focus on profitability are coming back into the fold. We see an interesting opportunity at the right price.
Cross-asset barometers such as the performance of Asian high-yield debt relative to that of US HY credit suggest to us that the performance of the broader MSCI EM equity index relative to that of the developed market index has lagged the narrowing in credit risk triggered by the reopening in China. Our view on emerging market Asia equities remains ‘favour’.
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