Swiss private bank Julius Baer discusses the outlook for equities and US government bonds.
Mathieu Racheter, head of equity strategy research at Julius Baer, believes that the secular bull market is still alive and that markets will move higher into year end after the seasonally weak period of August to October.
From a regional perspective, Racheter favours US over European equities, with a focus on quality growth names coupled with some defensives plays. “After a strong performance in the first seven months of 2023, developed market equities have started to correct in August. Increasing concerns about a balance sheet recession in China and a relentless rise in US Treasury yields were among the main drivers for the sell-off,” Racheter said in a statement.
As tactical indicators have normalised from depressed levels at the beginning of the year, he highlighted that equity markets are vulnerable to a short-term correction, which would be a welcome development to restore market health.
“The domestic economic backdrop in the US continues to be on a solid footing,” he added. “Leading indicators have recently picked up again, while the disinflation process remains intact, allowing the US Federal Reserve to conclude its hiking cycle,” he continued. This reinforces Racheter's view of a soft-landing in the US, and he recently lowered the recession odds to 30 per cent from 50 per cent. Moreover, an inflection point in earnings has been reached: earnings revisions have recently turned positive again, especially in the US, after having stayed in negative territory for 14 months, he said. This usually goes hand-in-hand with positive equity returns over the subsequent six to 12 months. Against this backdrop, Racheter recommends using temporary setbacks to increase the equity allocation. From a regional perspective, he favours US over European equities with a focus on quality growth names coupled with some defensives plays.
Meanwhile, Markus Allenspach, head of fixed income research at Julius Baer, recommends locking in real bond yields with quality longer-duration bonds: “The surge of US Treasury yields reflects overly optimistic growth assumptions and fears of supply we do not share.”
“Yields of US government bonds continue their painful rise to, or even above, the highs of October 2022. Back then, it was the fear of persistently higher inflation that caused the increase of rate expectations and yields, while it is the real yield component that is on the move right now,” he continued.
“In fact, the break-even inflation rates that compensate investors for future inflation are relatively stable in a range of 2.1 per cent to 2.3 per cent. In contrast, the real bond yields have more than doubled from their lows after the banking crisis in March. The real yield of the US inflation-linked two-year Treasury notes (TIPS) surged from 1.5 per cent to 3 per cent, while the equivalent for five-year and 10-year TIPS doubled from 1 per cent to 2.2 per cent and 1.9 per cent, respectively,” he said.
Allenspach highlighted four factors for this move to post-Lehman records. “First, the resilience of the US economy, confounding expectations that higher rates would slow housing activity, consumption, and capital spending. Second, the surge of supply as the US Treasury needs to refinance a material revenue shortfall. Third, foreign central banks are said to reduce their US Treasury holdings, adding to the supply overhang. And last, but not least, is the debate that artificial intelligence is permanently boosting productivity and growth, which will result in a higher natural (neutral) real interest rate level,” he said.
“Not all these arguments can be rejected easily,” he continued. “Our economists share the view about the long-term natural rate component and better growth outlook and have thus moderated their view on Fed rate cuts next year. That said, the bulk of US Treasury supply for the current fiscal year is behind us. And the Fed Atlanta index is notoriously volatile,” he added. Allenspach awaits a consolidation of the US Treasury market until the Fed gives new directions at the Jackson Hole conference in a week’s time.