Issues around US tech, China, US Treasuries and Japanese monetary policy have hit the headlines in recent weeks. Sunil Krishnan explains how taking a long-term view can help multi-asset investors cut through the noise.
Read this article to understand:
- Why the recent correction in equity markets has presented opportunities
- How emerging markets are suffering from a lack of confidence within China
- Why global bonds still offer diversification
At the start of the year, many investors wondered whether there was any positive case to be made for risk assets, with recession fears growing as central banks continued tightening policy. But equities confounded expectations, performing strongly in the first half. We have recently seen a small correction, but without a great deal of volatility or volume, so overall, 2023 has been positive for risk assets so far.
For those who were underinvested and those who participated in the rallies, the question now is whether enough is enough. Broadly speaking, we maintain a positive view on risk assets, using the August correction to increase our equity positions.
The first reason is sentiment. While certain investors, such as quantitative buyers who follow trends, are quite well invested in the market, institutional investors haven't entirely abandoned the concerns they had at the start of the year. The continued upward march in markets has gradually – albeit not completely – forced them to face up to the fact they might be underinvested, so we have seen a continued pace of inflows and don't feel that process is over.
The second reason is a set of fundamental drivers. We are approaching the peak in interest rates. Crucially, the range of possible interest rates in the coming months has narrowed, particularly in terms of how far they could rise, as the tightening cycle has progressed. However, the situation is different from 2022, when investors thought reaching a peak in interest rates would require a drop in growth that would challenge company profits. In fact, company profits have held up well.
Company profits have held up well
With second-quarter reporting now complete for S&P 500 companies, the average earnings surprise was just over seven per cent positive, accompanied by a positive revenue surprise of about two per cent.1 Companies have validated the continued positive sentiment.
Tech and AI: A happy few?
A major reason for the strength of US stocks this year has been the contribution of a small number of companies, alongside a powerful narrative around the potential for artificial intelligence (AI) to transform these businesses. Chipmaker Nvidia is the most obvious example. The company has a talent for reinvention, but now finds its processors central to AI development plans at its clients – including some of the biggest tech names. As a result, high profit expectations, underpinning high valuations, were beaten comfortably. Elsewhere, the impact is more incremental but remains encouraging, and recent corporate results show there is still scope for positive surprises.
Recent corporate results show there is still scope for positive surprises
Looking at broader equity market performance, the equally weighted S&P 500 has underperformed the cap-weighted one, showing the mega-caps have led the index. But we have continued to see gains in the broad index. That is an encouraging sign it is not just about narrow AI hype for a few companies, although we continue to monitor that trend. The positive sales and earnings surprises from all sectors apart from materials and utilities in the US offer encouragement on a fundamental basis.
Figure 1: Broader US equities have ground out gains
Source: Aviva Investors, Bloomberg. Data as of September 14, 2023.
We presume all companies will consider whether they have opportunities to enhance productivity. And there was some evidence from second-quarter reporting that companies able to demonstrate improvements, particularly in areas like customer service, were rewarded by investors.2
Where to now?
This combination indicates a possible soft landing, perhaps not strictly so in terms of the unemployment rate, but in that central banks could ease off on tightening while leaving companies able to maintain margins and sustain profit growth.
The outlook for the rest of the year will partly depend on how much of a lagged impact tightening has on the economy
The outlook for the rest of the year will partly depend on how much of a lagged impact tightening has on the economy, both the steps seen so far and possibly more to come.
Low Chinese confidence
With regards to emerging markets and China, investors started 2023 with optimism on the economic impact of post-COVID reopening.
We started the year with a similar view. But by the end of the first quarter, we felt the signs of a sluggish economic response to reopening were already evident, and that strong fiscal stimulus would probably not be delivered quickly either.3
One issue is that China seems to have a confidence problem. As an example, bank deposit levels are currently high in China at a time when performance in the property and stock markets has been weak. A lack of confidence is also coming through in terms of activity and signs of year-on-year deflation, for example in building materials and consumer durable goods like home appliances.4
Although the authorities would like to support growth and are willing to look at easing measures in terms of monetary policy and regulation, including loosening rules around house purchases, it isn't enough to rebuild confidence.
There also seems to be a reluctance to announce meaningful fiscal stimulus. One objective at the Politburo meeting in late July was to focus on economic policy. Some investors had hoped it would lead to more robust measures, but none came through.5
The environment requires caution, including on broader emerging market equities
That environment requires caution, including on broader emerging market equities, for three reasons.
Firstly, Chinese stocks account for over 25 per cent of the MSCI Emerging Markets Index. Secondly, the rest of the region's economic activity (Asia ex-China) remains highly influenced by its trade with China. Thirdly, demand for commodities and raw materials in areas like the metals market in Latin America tends to be driven by infrastructure and real estate investment in China, which has been weak.
For example, copper prices in Shanghai rose by about six per cent in the first two weeks of January but have hardly moved since. Similarly, copper prices in London rose more strongly, by about 12 per cent, at the start of 2023, but have since dropped back by a similar amount and are broadly unchanged on the year.6 That is not a sign of strength in the commodity markets that could improve the outlook for major resource players in emerging markets outside China.
As such, we still see emerging markets’ earnings momentum as challenged. We will monitor the situation closely because, if the Chinese authorities change the value they place on different economic objectives, that can lead to significant policy changes. But economic growth does not seem to be as big a priority for the Chinese Communist Party as it was in years gone by.
US Treasury supply: A short-term issue
Longer-dated US Treasuries have underperformed somewhat – the 30 basis points (bps) rise in ten-year yields outstripped a gain of just 13bps in two-year yields over the same period. This has led investors to question whether that was due to the country’s ongoing fiscal expansion, and consequent need to issue more long-dated bonds, while having seen a credit rating downgrade earlier in the summer.7
In the medium term, the interest rate outlook is more important than the supply profile
Growing supply to finance the US deficit can be an issue for relatively short spaces of time; it might affect the outcome of an auction or a series of auctions. But in the medium term, our base case is that the interest rate outlook is more important than the supply profile. For example, in recessions, supply increases materially, but it doesn't stop bond yields from falling. We are not too concerned about the supply profile affecting the US Treasury market as long as it doesn't disrupt the Fed’s efforts to reduce inflation.
Will Japanese yields ever rise?
Japan's policy has been fixed for years and remained so even as economic conditions began to change.
However, the data is now pointing towards a sustainable at or above-target pattern for inflation in the country. This paves the way for a gradual normalisation of policy in terms of yield-curve control. The Bank of Japan's (BoJ) recently announced change was carefully worded, maintaining the same band around its target yield but allowing for greater tolerance if that band is breached.8 That is the beginning of the end of the explicit, no-holds-barred desire to maintain fixed boundaries for longer-dated Japanese bond yields.
After the announcement, the yield on ten-year Japanese government bonds moved from 45-50bps to 60-65bps, despite the BoJ making purchases. That does not mean the bank is trying to resist a move to higher yields, but rather to control the pace of the change so it doesn't threaten financial stability.
The BoJ ultimately wants the ten-year yield to be set by markets
The BoJ will release new policy forecasts in October. We would expect those to show a further upgrade in inflation projections and potentially pave the way for a further policy adjustment. It is not guaranteed, but we believe the BoJ ultimately wants the ten-year yield to be set by markets and is trying to find a gradual path to doing that.
That sets Japanese government bonds up for higher yields over time. If anything, the BoJ’s recent announcement has increased our confidence it will not stand in the way of higher yields, even if it wants to manage their pace.