House View Q3 2024: Act on volatility

04/07/2024

Our view of global markets

Take the positives of a soft landing

Markets are on divergent paths. A spike in political risk – with elections in France and the UK in Q3 and the US poll looming in November – adds to a theme of regional differentiation.
Data increasingly points to a regional shift in growth expectations. We think this desynchronisation may generate opportunities across economies and asset classes.
Our conviction strengthens around a soft landing in the US and global economies, where growth slows – and inflation comes down – without risking a recession. This scenario will likely be positive for equities, which are set to benefit from positive earnings growth. But watch for volatility around market and political news.
Markets expect only 40bps of aggregate global rate cuts this year – down from three times that figure in early January. Different growth and inflation backdrops mean central banks have varying leeway to adjust their policy stance.
A rate cut in the US is now likely in September, in our view. We think markets are too cautious on further cuts, and investors should use this disconnect to strengthen positions in yield curve steepening and duration.

Chart of the quarter: That desynching feeling…

The European Central Bank (ECB) cut rates in June and markets anticipate the US Federal Reserve (Fed) and Bank of England (BoE) will follow – at varying speeds. The Bank of Japan (BoJ) is expected to move the other way.

Stay agile while being wary of political risks

The overall economic and market environment remains supportive of equities and bonds. A soft landing with lower inflation risk allows central banks to cut rates. In addition, company margins remain solid.
Political risks are acute. France’s elections may spark caution from European investors, at least in the near term. November’s US elections could mean the re-election of Donald Trump whose policies may have far-reaching consequences, including on tariffs where fault lines within Europe are already evident.
Progress has been made on inflation, but the last mile is often the hardest. While not our core scenario, we recognise the risks of a “no landing” – where the economy continues to run hot – which could be negative for bonds (and ultimately possibly for equities too).
But this is not a time to sit on the sidelines. US inflation is approaching target for the first time in two and a half years and improved Fed guidance allows the market focus to switch to politics and growth.
Even against the backdrop of overall slower global growth, an orderly rotation of growth expectations from region to region may be a healthy and stabilising development that supports the extension of the current expansion.

Consider the following:

Equities: We are positive about the enablers of AI adoption (eg, data centres, cloud providers) and green transition. Select European small caps stand out for their high-quality balance sheets. We think the UK looks cheap and politically benign.
Asia: Japan benefits from improving corporate governance. Investors might use volatility to target the more innovative and higher-yielding parts of China markets. We also like China government bonds.
Fixed income: Picking up the divergence theme, we prefer yield curve and cross-market relative value including curve steepeners in the US and euro area (eg, Germany). We are positive on UK rates given underlying fundamentals and political outlook.

See below for more details of our asset class convictions.

Different growth and inflation backdrops globally will give central banks varying leeway to adjust their policy stance. This environment could make for fertile hunting ground for active investors – but watch for political risk.

Asset class convictions

Equities

Fixed income

Multi asset

Asset class convictions: equities

Political vs economic cycles: volatility makes quality essential

Going into 2024, it was clear that this would be a major year for elections, with around 50% of the world population going to the polls. But the year continues to throw up political curveballs such as the snap election in France. Geopolitics have become omnipresent for markets.

This is against the backdrop of a more benign macroeconomic environment. The recent meeting of the Fed increased visibility on monetary policy. The takeaway for investors: while the economic cycle is crucial, greater clarity on the unfolding environment means the focus can shift to the political cycle. This message is coming loudest from the US, where the election looms in November and the re-election of Donald Trump could have global implications.

The interplay of the political cycle vs. the economic cycle is set to create more volatility for investors. While this volatility will likely offer entry points, it reinforces the need for quality in portfolios and careful portfolio construction. Focus on quality indicators, such as strong balance sheets and company leadership, when evaluating companies across growth, value and income styles.

Against this backdrop, here are several investment ideas we currently favour.

Tech: focus on the enablers and second wave of AI impact

Technology remains an interesting sector. Some stocks are richly priced – not least the Magnificent Seven companies that have been a major stock market driver in the US, particularly thanks to the boom in artificial intelligence (AI). So, we would look further afield within the sector, particularly at those companies that specialise in the enabling technologies of the AI boom such as cloud computing, data centres and application programming interfaces (APIs) – crucial parts of the AI “plumbing”.

In addition, while the development of the AI ecosystem is still in its early phases, the impact of applied AI on companies via productivity increases will be the next phase to be recognised by capital markets – AI’s second wave.

European small caps: small is beautiful

Europe’s approximately 5,000 listed small-cap companies include global leaders in attractive growth segments. Highly weighted in sectors such as capital goods and transport, small caps tend to be more cyclical and domestic than larger firms. This means they typically outperform when euro area growth accelerates. Hence the time to be positive on small caps could be when growth momentum is troughing and Purchasing Managers’ Indexes begin to rebound.

Perceived to be disproportionately reliant on credit, they have not participated in the cyclical recovery of recent months amid tighter credit conditions. But the environment could be turning in their favour as the ECB starts cutting rates. Furthermore, we think relatively low coverage by sell-side analysts could open up alpha opportunities for active investors looking for quality names.

Current relative value of large vs. small caps in Europe

Source: Allianz Global Investors, 9% valuation discount based on 12m forward PE vs. historic premium (+12%).

Asia: cheer for China equities – and is Japan the land of the rising markets?

We think there are reasons to be cheerful about Chinese equities over the longer term. The China A equity market is showing year to date gains after three years of bear market performance. Valuations are at historically low levels and forecasts for earnings growth are accelerating. The market is “under owned”. Plus, the government is sounding encouragingly proactive on boosting the economy and employment. Still, questions hang over the sustainability of growth, as well as the future of the beleaguered property market.

It is prudent to take a selective approach to Chinese equities, particularly as volatility may increase in the run-up to November’s US election and beyond. This means a focus on higher-yielding parts of the market: companies with higher dividends and share buybacks. Businesses boosting free cash flow by reducing capex requirements are attractive. We’re also looking to key growth areas supported by self-sufficiency, AI penetration and innovation. These may include firms operating within power grid infrastructure, semiconductor supply chains, AI-related fields and nuclear power.

We are also positive about Japan. The market experienced a major structural overhaul with “prime” companies required to meet new listing rules on liquidity, business performance and corporate governance. We think Japanese equities combine a reasonable valuation and strong recent earnings with a supportive growth environment amid the central bank’s continued efforts to stimulate growth.

Asset class convictions: fixed income

Watch for the yield curve to steepen

The economic landscape has changed considerably in recent years as inflation and interest rates have moved up. Yet, the US Treasury yield curve (among others) has not reflected the shift, staying remarkably flat relative to history. We think that is about to change.

We expect the US and German yield curves to steepen over the remainder of 2024. The catalyst? Central banks are embarking on rate cuts, prompting a re-pricing of front-end yields. Consequently, we expect the “term premium”– the extra yield investors demand for holding longer maturity bonds over shorter ones – to rise, weighing on ultra-long maturity bonds.

US and German yield curve steepening trades should benefit. In contrast, in Japan, we expect policy interest rates to be normalised over the coming years in the face of rising inflation expectations – a move that should drive a flattening in the government bond curve.

Flat vs steep curves: US 5s30s and Japan 7s30s, bps

Source: Allianz Global Investors, Bloomberg, 31 May 2024.

Opportunities of divergence

Market participants might be forgiven the occasional yawn in recent years as major developed government bond markets have moved virtually in lockstep. But this is no longer the case.

Opportunities now abound as countries and regions move in a less synchronised way. We see differences emerging in monetary and fiscal policy, exacerbated by political tremors. And government debt burdens may diverge. The shifts could present attractive returns from relative value positions in the months ahead.

As an example, the strength of the US economy has led to a dramatic scaling back in the market’s expectations for 2024 interest rate cuts. Dynamics in the UK economy are different. Below-trend growth, fiscal restraint and an attractive valuation backdrop, given restrictive real rates, favour an allocation to UK gilts on a cross-market basis.

We see other similar opportunities emerging – giving market participants plenty to think about.

Asset class convictions: multi asset

UK: back to being boring?

After Brexit, the short-lived Liz Truss premiership, and multiple changes of prime minister, the UK may – finally – be regaining its reputation for being boring. Its relative stability now compares favourably with the upheavals seen elsewhere.

This new-found predictability, combined with its status as one of the cheapest markets in the world – even on a sector-adjusted basis – could make the UK worth a serious re-evaluation, particularly as earning revisions start to improve. Other factors in its favour include:

Macro data is improving, showing more positive upside surprise than other regions.
Better business and consumer confidence data is starting to translate into improving retail sales.
Many investors are currently underweighting the UK and so as growth continues to improve, and the political noise of July’s election is out of the way, there’s potential for investors to reallocate.

Surge of interest in European banks

The re-emergence of significant positive interest rates has been a game changer for European banks. After a decade of trending down and reaching effectively zero just two years ago, interest rate margins of historically “normal” levels are now attainable again.

This regime shift has resulted in very strong earnings growth, and profits in 2023 reached three times the average of the preceding decade. Banks are likely to maintain similar profit levels for as long as interest rates stay above roughly 2%, where they can defend their margins – which builds the structural investment case.

Naturally, there are also risk factors that require close monitoring including higher-than-expected loan losses, the political situation in France, and the possibility of taxes on “windfall profits”.

Nonetheless, we believe this could be an overall attractive opportunity as, despite the strong momentum (+23% year to date), European banks still look far from expensive: at less than 7x earnings (US banks: 12x) they have substantial room to re-rate, especially given the current improvement in European economic data.

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