Monthly Investment Letter: Investing at the limit

The good news is that we may be hitting the limit for US interest rate hikes in this cycle. The bad news is that we are just weeks away from hitting the limit for US government borrowing, and a compromise in Congress has yet to be reached, although as of this writing there are reports that a deal is close.

So far, equity markets seem to be focused on the good news. Despite the risks, the S&P 500 remains close to a one-year high, and the VIX index of implied equity market volatility is trading at 17, below the long-term average of around 20.

With much of the good news seemingly priced in the market, the next few weeks could see us test the limits of how much risk equity markets can absorb. And in this context, we see better risk-reward in bonds than in stocks. In our view, defensive, higher-quality segments of fixed income offer both attractive absolute yields and a hedge against growth and financial stability risks. Valuations are also appealing on a relative basis: The US equity risk premium (based on the earnings yield) is now 44% below its 10-year average, meaning high-quality bonds are more attractive than US equities.

In equities, we view the US as the most vulnerable regional market. Given a rally driven by only a handful of names, relatively expensive valuations in large-cap growth and technology stocks, and the negative impact of credit tightening on company earnings, we expect higher volatility in the months ahead, and see the S&P 500 at around 3,800 by December. We prefer emerging market stocks, which should benefit from peaking US rates, higher commodity prices, a weaker US dollar, and China’s recovery.

Elsewhere, we maintain gold as most preferred and the US dollar least preferred. The US has enjoyed a growth premium relative to the rest of the developed world in recent years, but we believe this will erode and expect other central banks to continue hiking rates after the Federal Reserve has taken a pause. A weaker dollar and lower rate expectations should support gold prices, and we also see benefits in holding the yellow metal as a hedge against geopolitical risks and the debt ceiling standoff. We forecast gold prices to rise to USD 2,200/oz by March next year.

In the remainder of this letter, I address six of the most frequent questions clients have been asking me recently.

What happens if the US debt ceiling isn’t raised, and what should I do?

Large parts of the financial system are built on the premise that US government bonds will always be repaid in full and on time. That explains why Treasury Secretary Janet Yellen warns of “economic catastrophe” if Congress fails to reach an agreement to raise the debt ceiling—a legislative limit on how much the federal government can borrow without new Congressional approval. The Treasury currently estimates the US might exhaust its capacity to honor its obligations by 1 June (the "X-date").

In our base case, we still think Congress will come to an agreement to raise the debt ceiling, as it has on 89 occasions since 1959. Indeed, so far, equity markets have reacted little to the impasse. But negotiations are going down to the wire, and, as such, the risk of an accident has risen. Y ields on 1-month and 3-month Treasuries have increased sharply, with spreads on 1-year US credit default swaps hitting an all-time high of more than 170 basis points (though still implying just a 3–4% probability of default).

If Congress fails to reach an agreement before the X-date, we would expect the Treasury to prioritize using incoming tax revenues to ensure interest payments continue to be made while the government sharply cuts spending in other areas. We would also expect the Fed to provide liquidity to the financial system and prevent a potential seizure in short-term funding markets. While this approach may alleviate systemic risks, delays in government transfer payments would likely trigger a rapid loss of consumer and business confidence, demand destruction, and an increased risk of recession.

In terms of the market impact, we estimate the S&P 500 could fa ll quickly by more than 10% in this scenario as markets reprice the growth outlook and heightened systemic risks, though it could recover a meaningful portion of this loss if market turmoil pressures Congress into reaching agreement. Investors seeking to mitigate equity market volatility may wish to consid er structured investments or tilting their exposure toward more defensive sectors.

We think longer-dated Treasury bonds could sell off initially in response to any default, but we would also then expect them to rally back as ma rkets price a heightened probability of recession. For US investors, longer-dated tax-exempt municipal bonds, which are more insulated from market volatility than investment grade corporate bonds, also have the potential to stand out.

A default and subsequent Fed intervention would likely undermine the value of the US dollar, and we would expect gold to gain market favor, as it has in previous debt ceiling stalemates.

Should I worry about US regional banks?

Since the collapse of Silicon Valley Bank in early March, a negative feedback loop has put banks under pressure. The decline in regional banks’ stock prices has led to concerns about deposit flows. This in turn has led to concerns about the risk of bank runs, which, in tur n, has led to further stock pressure. At the time of writing, the KBW regional bank index remains 32% below its February peak, prior to SVB’s collapse.

Thus far, three midsize regional banks have failed this year. The Federal Deposit Insurance Corporation has provided a backstop for their uninsured deposits. In addition, the Fed has introduced a new Bank Term Funding Program, allowing banks to take one-year loans using their securities portfolios as collateral, which would be valued at par, thereby avoiding the need to realize mark-to-market losses.

The regulators' response to date has failed to fully restore confidence. This is understandable for a number of reasons.

First, since 2013, several years after the global financial crisis, an average of seven US banks have still collapsed each year. History suggests that the risk is for more failures this year.

History suggests that we may seemore bank failures this year.

Second, losses on uninsured deposits have occurred at small banks, not the largest. Until this year, the overwhelming majority of bank failures in the last three decades has occurred in smaller banks with less than USD 10bn in assets. The three bank failures this year have been large, involving a total of USD 548.5bn in assets, helping explain why the FDIC moved quickly to guarantee deposits. But the FDIC is unlikely to guarantee all deposits, which would require an act of Congress.

Third, given the above, it is logical for depositors holding funds in smaller banks with less diversified business models to avoid risk and shift the ir money into the large universal banks. This is particularly the case given the typical delays in recovering funds during a bank failure and the ease of moving capital in the era of digital banking.

So, the negative feedback loop looks likely to persist for a wh ile, with further noise surrounding pressured regional banks. Higher funding costs and greater liquidity needs will weigh on weaker banks’ profitability. This does not mean the situation will spiral into a full-blown crisis. We believe that the US regional banking sector in aggregate has adequate capital and liquidity. Most important, the FDIC, the Fed, and the Treasury are watching the situation vigilantly for signs of systemic risk.

What should I do with technology stocks after the rally?

After selling off by 40% last year, large US tech companies have performed well so far in 2023. The FANG+TM index, which includes the 10 most highly traded tech giants, is up 48% this year versus 8% for the S&P 500. Meg a-cap tech stocks received a boost from the first-quarter earnings season, which, though weak in absolute terms, pointed to a shallower decline in ear nings than feared. Markets also welcomed several top tech companies’ resilient margins and distributions to shareholders.

Still, we keep the technology sector as least preferred. Global tech stocks are now trading at more than 23 times 12-month forward earnings, a 32% premium to the average of the past 20 years. On a price-to-book ba sis, the MSCI All Country World technology index is trading in the 90th percentile of the past 20 years’ valuations. The MSCI USA tech index is even more expensive, at 24.5 times 12-month forward earnings, a 34% premium to its 20-year average. In addition, tech valuations’ historical correlation to US real interest rates has decoupled in recent months as the sector continues to rally while real rates remain unchanged.

With a 22.5% weighting, tech is the largest single sector in the MSCI All Country World Index, so it remains an important component of a well-diversified long-term portfolio. However, we think investors should use the recent rally as an opportunity to review and manage their exposure to the sector.

Investors should use the recent tech rally as an opportunity to review their exposure to the sector.

Investors who hold above-benchmark allocations to the sector should consider replacing direct exposure with capital preservation strategies, or rebalancing portfolios toward more defensive sectors, such as consumer staples and utilities. These sectors would likely outperform technology in the event of a recession and are trading at cheaper valuations. For investors who have exposure well below their strategic benchmark, adding to the sector could mak e sense despite our negative view, but we would recommend focusing on more defensive parts of the sector, such as software.

What should I do with commercial real estate holdings?

Commercial real estate has become widely cited as one potential risk area in the coming months as the sector adjusts to the post-pandemic increase in office vacancy rates, high refinancing costs, and news that some leading asset managers have chosen to default on some office-backed loans.

To be sure, the lower-quality segment of the bifurcated US office market faces challenges. But it’s also important to remember that commercial real estate is made up of more than offices, and its more defensive areas have stronger fundamentals.

In logistics, for example, supply has been crimped by more conservative bank lending standards and higher construction costs, while demand is growing in line with secular developments such as rising e-commerce penetration. We also think US multifamily apartments should be well supported by a structural lack of supply and stable occupancy rates.

At first glance, less liquid real estate assets may not look attractive relative to highly rated government debt yielding 4–5%. But a simple yield comparison between the two asset classes overlooks future reinvestment risks for bond investors and the potential for real estate yields to grow over time. From a portfolio perspective, we think the case for private real estate as a diversifier remains intact.

Historical annual returns, volatility, and correlation data from the past 25 years show that allocations to private real estate can complement bonds as a source of income, and its low or negative historical correlations with equities and bonds show how private real estate can help smooth portfolio returns through a market cycle.

Why are Chinese equities weak if the economy is recovering?

One of the biggest economic surprises of the year was China’s speedy reversal of its zero-COVID policy. Yet despite a strong 34% rally from last October’s crisislevel low, the MSCI China Index has given back January’s gains and is now 2% lower year-to-date.

Concerns over the robustness of China’s economy and geopolitical risks have weighed on the market. But, in our view, increased clarity on geopolitical risks and an earnings recovery should act as catalysts for Chinese equities in the months ahead. Sentiment can turn quickly in a market trading at depressed valuations (on a price-to-book basis, MSCI China is 1.2 standard deviations below the historical average since 2016), just 15% away from October levels.

1. First, while growth may be peaking, corporate earnings are not. After a surprisingly robust first quarter, manufacturing purchasing managers’ indexes dropped back to contraction territory in April, and weak inflation and imports, which fell 7.9% from a year ago, point to subdued domestic appetite for goods. Yet, we think company earnings have bottomed out and should now improve to an almost 14% growth rate for 2023 thanks to better economic conditions and an improved picture in property earnings. Overall profits rose 1% in the first quarter—in sharp contrast to the 15% decline in 4Q22—and earnings growth has historically been a reliable driver of Chinese equity returns.
2. Second, geopolitical risks may be overstated. Of particular concern is a potential US executive order that limits outbound investment to sensitive high-tech Chinese sectors. The fear is that this measure could be broad in scope and induce forced-selling. Our view is that it would likely focus only on new investments and be limited to industries such as artificial intelligence, high-end semiconductors, and quantum computing. In this event, while these sectors may experience elevated volatility, the announcement of such a plan would remove an overhang and reduce uncertainty in the market.

Is now a good time to start making long-term investments?

Amid relatively high interest rates on cash and short-term bonds, high US equity market valuations, and debt ceiling and recession risks, many investors have asked me whether it is better to wait on the sidelines before putting their money to work for the long term.

Investors should avoid the temptation to wait on the sidelines, and should continue to invest for the long term.

While we don’t think the risk-reward trade-off for equities is good from a tactical perspective, strategic decisions need to be made with a longer-term perspective.

1. Interest rates won’t stay high forever, so investors need to plan now how to earn more durable income and returns. In the last two interest rate cycles, the Fed cut rates close to zero and held them there for an extended period. We think investors should use this period of high interest rates to lock in yields for the longer term—by adding positions in medium- and long-duration fixed income, real assets that provide an income, or stocks of companies that generate quality income.
2. There’s more to an equity portfolio than just the S&P 500. Sure, the US equity market is the world’s largest and often the biggest single component in a well-diversified portfolio. But other assets and markets look more attractively valued. For example, MSCI EMU, the Eurozone equity benchmark, is trading at 12.3x forward P/E, and MSCI Emerging Markets is at 11.7x, while high grade (government) and investment grade bonds are also appealing in general.
3. It’s never certain there will be a better time to buy in the future. While our central scenario does assume the S&P 500 will fall over the balance of the year, we also consider an upside scenario wherein markets continue to rise. So far, with inflation surpassing wage growth, consumers have been saving less, drawing down savings, or borrowing to meet living expenses. Yet credit card delinquencies remain low, real incomes are rising as inflation falls, and consumer confidence is improving. If the US consumer can successfully “bridge the gap” until real wage growth becomes positive, economic growth may prove more robust than we expect, and markets may continue to move higher.

In our upside scenario, we see the potential for a roughly 13% gain for global equities (MSCI All Country World Index) by December, and 6% for the S&P 500. Under such conditions, deposit-heavy investors would be left with a classic reinvestment risk dilemma: buying stocks at a higher price or waiting in increasingly lower-yielding cash.

Investment ideas

Fixed income: Falling inflation and slowing growth mean short-term interest rates are in the process of peaking. We therefore believe investors should act soon to seek more durable sources of income, such as in high-quality bonds.

The more defensive, higher-quality segments of fixed income look most appealing to us, given the all-in yields on offer and potential for capital appreciation as investors shift focus from inflation risks to growth risks. Lower-quality segments of the asset class, such as high yield credit and loans, should also deliver a positive return over the balance of the year, but risks here are higher, given the potential for an uptick in corporate defaults and liquidity risks.

Equities: We see the risks to US equities as tilted to the downside, and advocate diversifying or implementing strategies that protect against the downside. The rally in the S&P 500 has been narrow—100% of its year-to-date gains is attributable to only the top seven stocks. Historically, this behavior has characterized a late-stage bull market rather than the start of a more prolonged upswing. And the index’s forward P/E of 18 times is historically consistent with consensus earnings growth expectations closer to 14% (well above today's 5%) or a 10-year Treasury yield less than 2% (well below today's 3.58%).

On the earnings side, credit conditions for US businesses and households have continued to tighten. According to the Fed’s latest quarterly Senior Loan Officer Opinion Survey, a net 46% of banks (versus 44.8% in January) made lending standards stricter for midsize and large businesses. The difference between loan demand and loan supply (banks willing to lend) is now at a level that in the past has been associated with a recession and is likely to weigh on corporate profits. We expect a 5% contraction in S&P 500 earnings this year.

We prefer emerging market equities. China accounts for 32% of the MSCI EM index, and our favorable view on China (for reasons discussed above) underpins our preference for emerging markets. But there are also numerous opportunities beyond China, such as Korean equities and select Asian semiconductor companies. Inventories and pricing pressures across Asian technology supply chains have likely peaked, and the second quarter could mark the trough in earnings before an improvement in consumer demand drives stronger revenue growth later in the year. We also see long-term opportunities in emerging market infrastructure, where we expect annual spending to reach USD 5.5tr by 2025, which equates to mid- to high-single-digit growth between now and 2025. Finally, we see opportunities in smaller emerging and frontier markets as supply chains shift.

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