Horizon Q4│2023 - Multi-asset strategy

Third quarter: "High(er) for longer" narrative boosted real yields and slowed down equities and government bonds

The developments from the second quarter initially continued in Q3. Thanks to a robust US economy, US equities and their valuations continued to rise, ignoring high and rising real interest rates as they have since May.

The picture turned in August. With the US economy still robust, oil and industrial metal prices rising again and core inflation still high, the markets priced out the expected rapid interest rate cuts by the US central bank. Nevertheless, the yield curve steepened. This is because the real yield on 10-year inflation-indexed US government securities climbed to almost 2%, the highest level since 2009, driven also by strong issuing activity (budget deficit) and the withdrawal of liquidity (QT). This weighed on equities and bonds at the same time – equities and government bonds returned to a positive correlation, equity markets lost about 5 % from the peak, higher-valued technology stocks suffered particularly and commodity prices recovered – the markets experienced a small "revival" of the developments of 2022. However, the increase in equity volatility remained limited, so that highly positioned systematic investors only sold off equities to a limited extent. There was no volatility spike that would have triggered a wave of selling by systematic investors and thus a more significant correction.

US data turns — US economy sets for landing

The economic downturn in the US has so far been a long time coming – unlike in the eurozone or China, economic data there continued to surprise on the upside in the third quarter.

But in the US, too, signs of an economic slowdown are mounting. Not least, monetary policy has reached a restrictive level in recent months, with a positive real central bank rate of more than 1.5% (Fed rate of 5.25–5.50% versus consumer price inflation of 3.7% in August). The US unemployment rate has risen from a low of 3.4% in May to 3.8% in August. Even though the participation rate rose somewhat in parallel, the labour market is showing signs of cooling. Against this background, for Europe as well, no recovery is to be expected in the coming months. But after the wave of massive disappointments since spring, the negative surprises are likely to subside. Likewise, there are no clear signs of positive economic impulses from China as long as there are no stronger stimulus measures. For markets, this means that there are unlikely to be any positive signals from the economy in the fourth quarter and the question of the strength of the US slowdown is likely to be in focus.

Bonds from safe issuers could benefit

Against this backdrop, safe havens such as government bonds are likely to outperform risk assets in Q4. As long as inflation does not firm up again, which is a risk given the significant rise in commodity prices, bond yields should rise little, if at all, while the current yield is already attractive. Should the US economy weaken more
markedly, safe haven bonds should benefit more significantly – this is an attractive asymmetric yield profile, especially as speculative investors have strong short positions in US Treasuries and 10- year US Treasuries have a real yield of almost 2%. However, investors from the euro area should not forget the currency risk. The
US dollar remains heavily overvalued and is likely to depreciate significantly over the medium to longer term. Alternatively, hedging the currency will cost. However, the real yield on 10-year Bunds is just positive at 0.2%. High-quality covered and corporate bonds offer more yield and we prefer these in Europe. Risk premiums
have generally narrowed considerably, so the risk of rising spreads exists. Shorter maturities are to be preferred here. Interest rate duration should therefore be built up via safe bonds. Overall, we prefer bonds to equities, but a strong absolute overweight does not seem obvious, also in view of the continued high interest rate volatility.

Upward breakout of equities unlikely for now

Valuations of US equities in particular are significantly elevated by historical standards – despite high bond yields. The optimistic earnings estimates for 2024, driven by a strong expected widening of profit margins, also make positive surprises difficult. Admittedly, producer price inflation is currently coming down faster than
consumer price inflation, a classic margin driver. But consumers are becoming more cautious. A more pronounced economic slowdown is more likely to lead to a reduction in profit expectations. Support from equity fund inflows remains very limited and systematic, risk-based investment strategies are highly positioned in
equities. This suggests a continuation of the back and forth of the last two to three months with the risk of a more significant correction should a volatility spike trigger a sell-off by systematics. It is conceivable that with the economic outlook for 2024 at the end of the year, investors' gaze will already shift to a possible global upswing in 2024 – especially if the US economy has cooled down more significantly by then and inflation is lower. In our view, however, this has become less likely.

The expected environment suggests that investors should again pay more attention to the quality of corporate earnings and structural earnings growth. This, combined with stable or falling bond yields, should allow quality and growth stocks to outperform in relative terms again in the fourth quarter. Without an investor focus on economic recovery, however, small caps are likely to continue to struggle for the time being despite attractive valuations.