PERSPECTIVES
MARKET AND ALLOCATION
Our experts monthly overview
OUR CENTRAL SCENARIO
Deputy Chief Executive Officer,
Chief Investment Officer
OFI INVEST ASSET MANAGEMENT
And we’re off! After a status quo of more than one year at 5.50%, the US Federal Reserve has begun a cycle of lowering its key rates. Through a first, 0.50% move, which was higher than we expected, Jerome Powell is assuming that the pace of inflation has slowed enough to ease monetary conditions but while insisting that he will be on high alert to keep growth from slowing too much. For, as we mentioned last month, the markets have now cast their gaze on US economic activity, fearing a hard landing. Our scenario is that the US economy will slow in orderly fashion, but without triggering a recession.
Against this backdrop, the Fed is expected to continue lowering its rates until it hits about 3% in 2025, which has more or less already been priced into the curve.
In Europe, the European Central Bank (ECB) lowered its key rate by 0.25% and is expected to stick to this trajectory until it hits a 2% neutral zone in 2025, against a backdrop of a tentative restarting of growth.
Based on expectations already priced into the curves, we therefore reiterate our neutral stance on nominal rates in both the US and Europe. Tactically, in the short term, they are no doubt slightly overbought, but the risk looks asymmetric with regards to growth, and the geopolitical context calls for keeping duration.
We have ultimately taken profits on corporate bonds after several quarters of long positions, not out of any real concern over the asset class, but to lock in returns, particularly by high yield, in both its rate and spread components. We expect to have some opportunities in the coming months to reopen positions.
The inflation break-even point, in Europe in particular, looks attractive in light of inflation priced in at current levels (1.75% over a period of 10 years), as well as emerging market debt, which is likely to get a boost from future Fed moves.
We are making no change to our neutral stance on the equity markets, in which future revisions to earnings forecasts, and the difficulties of switching margins from being price-driven to being volume-driven are occurring against a backdrop of monetary easing. In our 2025 growth scenario, we will take advantage of phases of volatility triggered by third quarter results or the geopolitical context to once again increase our weightings to the asset class, similar to what we experienced in August.
OUR VIEWS AS OF 07/10/2024
Driven by ECB and Fed rate cuts, the bond markets ended September in positive territory. Monetary policies are likely to continue to be adjusted at a gradual pace. However, we believe the markets are still a little too optimistic in their expectations, and bond yields look a little low. Pending a return to duration, our preference will be for real rates. Intra-euro zone spreads may also offer tactical opportunities, particularly for France or Italy. As we noted in September, we believe that the bond markets have already achieved a considerable portion of their performance expected for 2024. We had switched to a neutral stance on government bonds and investment grade corporate bonds last month, and we are now also moving to a neutral stance on high yield corporate bonds, as well. While we still like that asset class, money-market funds and emerging market debt are structurally the best alternatives in the shorter term.
The decline in both long bond yields and central bank interest rates has, of course, driven US equity markets, which set new all-time records in September. However, the latest macroeconomic figures have cast doubt on companies’ ability to preserve their margins. The slightest profit warning is being punished severely, such as what occurred recently in the auto sector. Although, in historical terms, Western markets are priced within their range of the past 30 years, if they are to keep moving up they will have to provide evidence that 2025 earnings will, at very least, equal those of 2024. Pending greater visibility on this outlook, we reiterate our neutral stance on the equity markets, while being alert to a possible consolidation in the last months of the year, before becoming more bullish. With gains of a little more than 7% on the year to date, euro zone markets have reached the levels that we had set at the start of the year, while US markets have already surpassed them by far. We have raised our exposure to China one notch in the wake of the official stimulus, the extent of which was not expected and with investors having headed massively for the exits over the past several months. The rally in China could go on, given its relative valuation, which is still low compared to Western markets.
September ended without any strong trend, either for the dollar or the yen. Since soaring during the summer, the yen has levelled off. The Bank of Japan (BoJ) left its key rate unchanged in September. Total year-on-year inflation in Japan hit 3% in August, a 10-month high, and more very gradual rate hikes are expected. However, the BoJ is being careful with its language, in order to forestall any further turbulence on the financial markets.
MACROECONOMIC VIEW
GROWTH HAS TAKEN OVER FROM INFLATION
Head of Macroeconomic Research
and Strategy
OFI INVEST ASSET MANAGEMENT
SOLID US FUNDAMENTALS
Revised US national statistics show that the post-pandemic recovery has been even stronger than what the numbers had so far suggested. Not only was GDP revised upward, but household income was revised more than household consumption (and investment), due mainly to the increase in interest and dividend income, corporate income and wage income. In other words, the household savings rate was revised sharply upward - from 2.9% of disposable income, close to its all-time lows, to 4.8%, i.e., its historical mean from 2000 to 2019. This is good news, as the recent strength of consumer spending mainly reflects growth of real income and not an unsustainable increase in borrowing or a decrease in savings.
THE JOB MARKET IS THE REAL KEY…
And, despite year-on-year growth of real income of more than 3% in 2024, household confidence has weakened, mainly because there are fewer jobs and they are harder to find. Against this backdrop, consumption can be expected to move back to normal but without collapsing, given how solid households’ finances are.
Even so, we are close to a turning point, as a further decline in available jobs could come with an increase in the unemployment rate, making the job market the key variable to keep an eye on in the coming months.
…AS IT WILL DICTATE THE PACE OF RATE CUTS
In choosing to start its monetary easing with a 50 bps cut in key rates, from 5.5% to 5.0%, the Fed showed how determined it is to ensure a smooth transition of the economy. If all goes according to plan, the Fed Funds rate should be at about 3% in the second half of 2025, i.e., around neutrality.
AN ECB RATE CUT IN OCTOBER?
In the eurozone, economic surveys remain glum, and the services sector also appears to have run out of steam after the Olympics splurge of last summer.
Recent surveys have tended to underestimate growth compared to the hard data. Even so, economic activity is unlikely to accelerate between now and yearend. The good news is in inflation, which in September fell below 2% for the first time since 2021. The energy component was a big contributor, but services also fell more than expected in some of the euro zone’s largest economies. The receding of inflation is likely to support household confidence and boost consumption. According to a model released recently by the ECB(1), the increase in inflation and in inflation expectations was the main cause of the decline in consumer confidence compared to the period just before the Ukraine invasion, ahead of negative impact of higher borrowing costs, combined with the decline in real-estate prices.
In reaction to the latest data, the ECB has altered its language. Even the most inflation-sensitive members of the Executive Board say that the ECB can no longer ignore the weakness in growth(2). A rate cut at the October meeting is now more likely, whereas we had not been expecting it to come until December.
INTEREST RATES
RATE CUTS AND STEEPENING
Co-CIO, Mutual Funds
OFI INVEST ASSET MANAGEMENT
The Fed ultimately pivoted after keeping its key rates unchanged at 5.5% for 14 months. The first, 50 bps key rate cut, on 18 September, was greater than we had expected just one month ago. The markets cheered this rate cut, along with the ECB’s 25 bps cut shortly before that. Against this backdrop, the US yield curve steepened for the fourth consecutive month, as did the German curve. We call this a bull steepening, i.e., when short-term rates fall faster than long-term ones. On the month, the US 2-year yield fell by about 30 bps, vs. only about 10 bps for the US 10-year yield, to 3.78%. The 10-year Bund yield, fell lower, to 2.03% on 1 October. Regarding sovereign spreads, Italian bonds outperformed throughout the curve with the 2-year yield down by 40 bps and 10-year yields by 25 bps. France was the only country whose spreads widened vs. Germany. The spread between 10-year French and German bonds widened by 6 bps to 0.79% at the end of September, as the fiscal standings of France and Italy diverged, with projected public deficits higher than expected in France and not as high as expected in Italy. It will be worth keeping an eye on France in the coming weeks, especially as the extent of the deficit could spur the ratings agencies into action as early as the month of October. France’s prime minister will also have to submit a credible plan to convince its European partners of its ability to rein in its public debt.
With inflation expectations still low in Europe and a decline in oil prices, the markets are now pricing in a rate cut by the European Central Bank at almost each meeting, beginning in October. As for the US Federal Reserve, the markets are pricing in an additional 75 bps in rate cuts this year, which would lower the Fed Funds rate to 4.25%. These rather rapid rate cuts would mean a new equilibrium rate for both central banks around mid- 2025.
In the short term, these rate expectations look a little overdone, and we prefer a neutral stance in terms of duration, pending better opportunities.
INVESTORS ONCE AGAIN PILED INTO CORPORATE BONDS
European bond markets once again performed well in September, driven by changing rates. However, the picture was mixed from one sector to the next. Most automakers lowered their earnings guidance, as the Asian market is weaker than expected at a time when Chinese competition is heating up in Europe, particularly in electric technologies. Memberstates’ diverging views on European trade policy could also have repercussions on other economic sectors in the coming months. This would not undermine companies’ capacity to refinance by tapping into liquidity and pricing conditions that continue to improve. The real-estate sector is the first beneficiary, with a complete reopening of the bond market in all European countries. Cyclical sectors are likely to benefit from the rebound expected in European growth as early as 2025. Euro investment grade and high yield corporate bonds continue to offer carry trade opportunities. However, in light of performances already in the books this year, the money market and emerging market debt look like the best short-term alternatives.
The spread between France and Spain on 10-year bonds as of 30 September 2024.
| BOND INDICES WITH COUPONS REINVESTED | SEPTEMBER 2024 | YTD |
|---|---|---|
| JPM Emu | 1.28% | 1.94% |
| Bloomberg Barclays Euro Aggregate Corp | 1.23% | 3.83% |
| Bloomberg Barclays Pan European High Yield in euro | 1.05% | 7.00% |
EQUITIES
RATE CUTS VS SLOWER GROWTH
Co-CIO, Mutual Funds
OFI INVEST ASSET MANAGEMENT
September was another month of gains on the equity markets. The Fed boost clearly played a part, but attributing these gains to that alone would be oversimplistic. The truth is that the soft landing of the world’s largest economy has been a big success. One year ago, there were still realistic doubts this would happen, and the markets were counting on a series of rate cuts to get the markets moving upward. We see now that companies have, on the whole, managed to keep their profit margins up despite lower volumes, amidst hopes of a more positive shift in 2025.
REPORTING SEASON UNDER THE MICROSCOPE
Even so, volumes have still not picked up. We knew that 2024 would be back-end-loaded, with cyclical improvements expected late in the year. The question now is whether central bank rate cuts will soon alter the behaviour of economic actors.
In the US, the recovery in investment spending will still depend on lower financing costs. Real-estate developers such as Pulte Group* and Lennar* have reported renewed interest in their residential projects, but without that interest translating yet into actual purchases.
Similar statements have been made by Home Depot* and Lowe’s*, with heavy spending on renovating taking time showing up. And Fedex*’s recent profit warning* suggests that the same is true of business investment. In its release, Fedex also said that no upturn in US manufacturing output would come until 2025. All this seems to cast doubt on consensus secondhalf earnings growth forecasts for the S&P 500, which are assuming a strong acceleration in the contribution by “traditional” sectors to earnings by S&P 500 companies in the second half of 2024. These expectations are all the more demanding as earnings growth from artificial intelligence (AI) ecosystems have already begun to slow since the end of June, due to the inevitable base effects. Investors’ enthusiasm also appears to be cooling off. After cheering the increase in AI investments (true, almost USD 300bn per year), they would like to start seeing some return on their investments in 2025. So, the coming earnings reports could therefore be more challenging and flag a return of volatility.
Europe is bogged down in economic sluggishness and political stalemates, and something that is hitting its industrial flagships hard. In September, successive profit-warnings by BMW*, Mercedes-Benz* and Stellantis* were the final blow to the European auto sector.
WILL SALVATION COME FROM CHINA?
Rumours of an imminent Chinese stimulus plan drove the markets late in the month, with an impressive rally in particular by European luxury leaders. The Chinese market soared by almost 25% in the second half of September, driven by hopes of another monetary and fiscal boost by the national authorities. A policy geared towards a short-term boost to growth would be a big change in paradigm in a country that is traditionally inclined to draw up long-term economic policies. The robust rally in Chinese stocks makes even more sense, as investors had fled those markets massively over the past few quarters.
Third-quarter earnings season will soon begin, but we will be paying special attention to guidance from companies on their 2025 business outlook. US and European markets, which are trading at, respectively, 24 and 14 times their forecast 2024 earnings, do not look overvalued but would not stand up to a significant revision in earnings forecasts. Against this backdrop, we are sticking to our neutral stance on equities while keeping the door open to a more constructive stance in the event of a consolidation during the quarter.
The amount of mandatory reserves freed up by the Chinese central bank during its recent rate cut cycle.
| EQUITY INDICES WITH NET DIVIDENDS REINVESTED, IN LOCAL CURRENCIES | SEPTEMBER 2024 | YTD |
|---|---|---|
| CAC 40 | 0.14% | 3.48% |
| EuroStoxx | 1.01% | 11.35% |
| S&P 500 in dollars | 2.10% | 21.70% |
| MSCI AC World in dollars | 2.32% | 18.66% |
EMERGING MARKETS
EMERGING EQUITIES: READY FOR A COMEBACK?
Chief Executive Officer
SYNCICAP ASSET MANAGEMENT
Since the 2008 financial crisis, a dominant US economy and tech sector have overshadowed other markets, emerging ones in particular. However, some more positive signs are appearing, perhaps pointing to a more bullish phase for emerging market equities.
Emerging equity markets have a track-record of letting investors down, dashing hopes of stronger economic growth. Equities in developed economies, particularly the US, have outperformed emerging markets by far (see chart). There are several reasons for this. Globalised trade since the 1990s has favoured large companies and global brands, creating international franchises. In addition, the agility of the Western capitalist model, embodied by the US, has made more efficient use of capital possible, particularly in the tech sector, thereby driving US market indices upward. In contrast, emerging markets suffer from governance that is too often overly centralised and opaque and in some cases corruption-ridden, thus undermining confidence in their financial ecosystem.
SOME SIGNS IN FAVOUR OF EMERGING MARKETS
These issues are well-known and won’t go away any time soon. However, emerging equities’ relative performances have been improving in recent weeks, and there are signs of a potentially more bullish phase for several reasons:
- The US economic slowdown: the US economy is entering a phase of slower growth. The IMF forecasts that the percentage of emerging economies in which per capita GDP could increase faster than in the US will rise from 48% to 88% in the next five years, reaching levels comparable to those of the boom in the 2000s, which was driven mainly by the rise of China and of commodity prices. The monetary easing that is now underway in the US could also weaken the dollar, something that historically boosts emerging market currencies.
- The emerging markets cycle appears to be more evenly spread and driven by other countries than China, which is currently mired in deflation and politically isolated. Both international and Chinese capital flows are being directed towards other emerging market countries, in order to work around excessive dependency on China in international production and distribution chains.
- Green tech exports: exports of green technologies are expected to be especially strong in the coming decade, along with the commodities needed to build them, such as copper and lithium, which are supplied mainly by emerging market countries. The AI (artificial intelligence) boom is already boosting exports by suppliers of chips (in Korea and Taiwan) and electronics (Malaysia and the Philippines). Investments are rising in many emerging markets, driven by various advantages - India’s vast domestic market, Malaysia’s fertile environment for datacentres, and Mexico’s proximity to the US.
- Rather attractive valuations: the 2024 P/E of the MSCI emerging markets index is currently forecast at 15. Earnings of companies in emerging markets excluding China are expected to rise by 22% in 2025, which would work out to a 2025e P/E of 12.3. What’s more, this figure is skewed slightly by Indian equity valuations (with a 2025e P/E of 24.5, justified by its strong growth). Conversely, the undervaluation of Chinese equities is worth noting (with a 2025e P/E of about 12), which prices in a political risk premium and the current low economic visibility. Moreover, profit margins are improving in emerging markets, while they have tended to stagnate in the US over the past 18 months.
In sum, we believe this is a good time for diversifying into emerging equities. Although China poses some specific challenges, these seem to have been priced in at current levels. The outlook is very bright for other emerging markets, particularly in Asia. We therefore expect a period of outperformance from emerging markets, despite Wall Street’s impressive domination.
This is the performance of Chinese stocks since mid-September. A “Beijing put”(3) could be a possibility, as the government has just taken several measures and seems determined to halt the negative economic and stock market spiral.
Performance of global equities and emerging equities since the 2009 financial crisis
Document completed on 07/10/2024
Carry: a strategy that consists in holding bonds in a portfolio, possibly even till maturity, in order to tap into their yields.
Carry trade: a currency investment strategy that seeks to exploit interest-rate differences between two currencies.
Convexity: one of the main objectives of convexity strategies is to maximise a portfolio’s resilience to shifts in interest rates and market conditions.
Duration: weighted average life of a bond or bond portfolio expressed in years.
Inflation: loss of purchasing power of money which results in a general and lasting increase in prices.
Inflation breakeven rate: the difference between the yield on a traditional bond (nominal yield) and the yield on its inflation-indexed equivalent (real yield).
Investment Grade/ High Yield credit: Investment Grade bonds refer to bonds issued by borrowers that have been rated highest by the rating agencies. Their ratings vary from AAA to BBB- under the rating systems applied by Standard & Poor’s and Fitch. Speculative High Yield bonds have lower credit ratings (from BB+ to D, according to Standard & Poor’s and Fitch) than Investment Grade bonds as their issuers are in poorer financial health based on research from the rating agencies. They are therefore regarded as riskier by the rating agencies and, accordingly, offer higher yields.
PER: Price to Earnings Ratio. A stock market analysis indicator: market capitalisation divided by net income.
Recession: a period in which a country’s economic activity shrinks, defined most often as decline in gross domestic product during at least two consecutive quarters.
Risk premium: reflects the additional return demanded by investors compared to a risk-free asset.
Spread: difference between rates.
Volatility: corresponds to the calculation of the amplitudes of variations in the price of a financial asset. The higher the volatility, the riskier the investment will be considered.
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