Bonds’ appeal rises as rate cuts loom

IN AUGUST, global purchasing managers’ indexes (PMIs) for manufacturing in advanced economies continued to point to declines in business activity. Services activity has held up better, but may not remain unaffected by the decline in manufacturing.

A slowing jobs market will contribute to a downturn in household spending and lead to a slowdown in the US economy. We expect three 25-basis-point rate cuts from the US Federal Reserve between September and the end of 2024, and four more in 2025.

But the Fed’s reaction to the slowdown in the labour market will need monitoring. While our base case is that the downturn in jobs will be manageable, downside risks are growing.

While recession may be avoided, the economic backdrop for equities is hardly optimal, especially in light of high valuations and expectations for earnings growth next year. The issue of high earnings multiples is especially acute in the United States, including parts of the Big Tech universe that now accounts for a sizeable chunk of the S&P 500. Question marks over whether investor enthusiasm for the artificial intelligence (AI) theme will continue, and the November election in the US, complicate the near-term outlook for US stocks.

Preparing for equity market turbulence

While the start of Fed monetary easing is set to support rate-sensitive equity sectors as well as small caps, and while our core view is that the US will avoid recession, equity valuations are high (especially for Big Tech) and earnings projections look generous amid indications of an economic downturn. We maintain our active, stock-specific approach to equities based on fundamentals.

With the decline in interest rates, we are less downbeat on small caps, whose less-aggressive valuations suggest they would benefit from a broadening out of market performance.

While there are question marks over tech, and specifically over how AI will pan out, we continue to hold a nuanced view of the sector. Valuations look high overall, but can be justified by continued growth in revenues and low debt levels in the case of a number of high-profile firms.

Investors are growing impatient to see the huge spending on AI turn into revenues; big tech companies can afford the investments thanks to their enormous free cash flow. Nonetheless, a tailing-off in the growth of AI investments could dent the enthusiasm surrounding big AI chip companies. A bottom-up, active approach to the sector is important.

Bonds come into their own

Thanks to a sharp decline in the stock-bond correlation, government bonds helped cushion portfolios during the recent spike in equity volatility. As policy rates come down, we have moved to an overweight stance on US Treasuries. We believe local-currency emerging-market government bonds offer attractive risk-adjusted yields as they come into their own as the Fed starts to cut rates and the US dollar sags.

We find selective opportunities in investment-grade corporate bonds. They held up well during the risk-off episode in early August, helped by the drop in government yields. We continue to focus on issues from corporates with strong fundamentals, including plenty of free cash flow. We also see improved potential in better-quality US high-yield bonds, which offer attractive carry and stand higher in the capital structure than equities.

Brighter outlook for Asian equities

The outlook for Asian equities may brighten as the prospect of the Fed’s first rate cut draws near. Historically, Fed easing cycles have usually benefited Asian equities, with South Korea and Asean equities among the most sensitive to the Fed’s rate cuts and the US dollar weakening.

After a long streak of downward revisions, the earnings outlook for Asean markets is turning up as well, especially for stock markets in Malaysia, Singapore and the Philippines. Valuations for Asean equities remain attractive, with 12-month forward price-earnings ratios at a 30 per cent discount to developed markets, or two standard deviations below the average of the past 10 years.

The performance of Chinese equities has remained muted so far this year. Although more government stimulus to support growth is expected before the year’s end, the choice of policy tool does not seem to be addressing some key investor concerns. In particular, household consumption will likely remain weak, and low inflation may persist. Both factors could continue to weigh on Chinese equities.

After outperforming the region for most of this year, Indian equities took a breather in August. Yet, despite elevated valuations versus other Asian markets, we maintain a structurally positive outlook on India.

Asian credit resilience

On the fixed-income front, Asian credit spreads proved more resilient than their US counterparts during the heightened volatility seen at the start of August. Widening of spreads in the main Asian investment-grade credit index was only half that of its US counterpart, and the same was true of Asian financial credits.

Overall, we view Asian credit as a good diversifier and shock absorber for portfolios, a point well demonstrated in the latest market rout. Our preference remains the high-quality segment, since Fed rate cuts, the US elections, and geopolitical uncertainty could mean more volatility over the rest of this year.

Take on more duration

Aside from the opportunity cost, we believe the attractiveness of cash will suffer as short-term policy rates decline. With yields still around 3.9 per cent on US two-year Treasuries, we believe that relatively short-term government bonds (up to five years maturity) are a more attractive investment ahead of cuts to policy rates.

At the same time, while yields have been falling in anticipation of rate cuts, the falls have been more pronounced on the short end of the yield curve.

We see this steepening of the yield curve as an entry point into longer-duration credit so as to lock in attractive yields ahead of rate cuts. Such a move could mitigate reinvestment risk and lead to potential capital appreciation. Furthermore, the decent coupon offered by bonds provides a cushion against any adverse movements in market prices.

The writer is chief Asia strategist and head of Asia research, Pictet Wealth Management