UBP House View - November 2023

Key takeaways

Editorial

Two years of transition in the money and interest rate markets have made it possible to return to more conventional investment ideologies in financial markets. After many years of zero or even negative interest rates, a more traditional hierarchy of risk premiums among the different asset classes has been restored in 2023.

Risk-free asset remuneration now means that bonds offer enough visibility to investors, while equities are presenting excess return opportunities. This has allowed traditional asset class arbitration mechanisms to come back into play and, as a result, equities have become more volatile. We can expect periods of low volatility (12%) to be a regime of the past, with levels of 15–20% more representative of future earnings uncertainty and exogenous shock risks.

Within bonds, the situation has been critical for the past two years after the complete recalibration of interest rates. 2024 should play to the asset class’ advantage, with inflation expectations returning to levels more aligned with market expectations.

In hindsight, the consequences of Covid will have provided central banks with a historic opportunity to reintroduce more orthodox monetary policies via their uncompromising fight against inflation. As a result, investors will have witnessed the “normalisation” of financial markets. However, one major question remains unresolved, namely the capacity of economies to absorb such an interest rate shock.

Strategy

Bond yields topping in the US and Germany...

With bond yields in the US and Germany having rapidly approached our target ranges of 4.5–5.0% and 3.0–3.5%, respectively, we believe yields have entered a topping phase on both sides of the Atlantic.

Inflation-adjusted yields in Germany are positive across the yield curve for the first time since before the global financial crisis. In the US, inflation-adjusted yields across the yield curve now sit above 2%, i.e. levels more consistent with “real” yields seen in the late twentieth century.

Though risks exist that could push yields even higher, including oil supply disruption or heavy US election-related fiscal stimulus going into 2024, at current yields the overall risk–reward has shifted from the asymmetrically skewed risk of higher yields outlined a year ago to one now skewed towards moderately lower yields looking into 2024.

As inflation expectations ease, we can expect high real interest rates in the US to allow nominal 10-year yields to retreat back towards 4.5%, and in Germany towards 2–2.5% in 2024. For investors who have been capitalising on high yields in deposits throughout 2023, an opportunity is emerging to begin deploying cash in high-quality USD and EUR bonds in 2024.

... likely easing global equity valuation compression

The move since mid-2023 to a new, higher range in US and German risk-free yields has driven a 10% valuation compression in global equity markets. Thus, as yields peak in the months ahead, the pressure on global equity valuations should likewise abate.

In equities, investors should focus on earnings recovery in 2024 to drive returns following the 2023 earnings recession. The earnings-led recovery in software and technology should be buoyed by AI spending, while quality laggards outside technology offer an opportunity to access strong balance sheets and reliable earnings growth.

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