House View Q4 2024: Shifting gears

Three reasons to like emerging market local currency bonds

Three factors underpin our positive view of emerging market local currency bonds. First, emerging market inflation has been falling at a faster pace than emerging market central banks have been delivering cuts. That means emerging market real yields are currently at multi-year highs, suggesting emerging market central banks have ample room to make further cuts. The start of the Fed’s rate cutting cycle should bring further momentum to rate cuts in emerging markets.

Second, the spread between local bond yields and US Treasuries has widened steadily over 2024, making for a compelling carry opportunity. Third, emerging markets growth looks resilient for this year and next and should easily exceed growth prospects in the developed world.

We foresee further downward moves in emerging market local currency bond yields in the coming months.

EM real rates are at multi-year highs, giving central banks ample room to cut policy rates

Source: Bloomberg, Allianz Global Investors, as of September 2024. Simple average for Policy Rate deflated by 12M CPI for the following countries: South Africa, Brazil, Mexico, Uruguay, Dominican Republic, India, Colombia, Romania, Hungary, Peru, Poland, Czech Republic, Chile, Indonesia, Malaysia, Thailand, China, and Turkey.

Focus on developed market sovereign bonds – particularly the UK

We are constructive on the outlook for sovereign bond returns, given the current global macro and policy backdrop. We favour a long interest rate duration stance in several markets and prefer to be positioned for steeper yield curves, especially in the US and euro zone.

Markets are beginning to pare back expectations for US growth, while European and Chinese growth remains lacklustre. Inflation pressures too are on an easing path, helped by sliding commodity and energy prices. We see opportunities surrounding a potential repricing in interest rate markets, particularly if the probability of a hard landing increases over the coming months and central banks front-load rate cuts. If inflation break-evens fall further as near-term inflation risks dissipate, we would also favour balancing our positioning by adding some inflation protection in portfolios.

We like UK Gilts on a relative value, cross-market basis against German Bunds. We believe that interest rate markets are insufficiently pricing Bank of England rate cuts over the next six to nine months in comparison to the ECB and Fed.

Equal-weight investments in the US stock market

The concentration in the US equity market is at its highest level since the 1970s, driven by the stellar performance of the Magnificent Seven. Concerns over their outsized influence make the equal-weighted approach compelling, offering diversification that reduces single-stock risks, as shown by Nvidia’s recent earnings reporting.

History shows that dominant companies rarely maintain leadership. Of the top 10 largest companies globally in 2010, only Apple and Microsoft remain. This is also substantiated by research indicating a long-term underperformance of the largest listed firms and supported by today’s valuation gap of 3x vs. 1.7x sales.

More tactically, our expected soft-landing scenario could broaden market participation as the earnings growth gap between the Magnificent Seven and the remaining 493 companies is expected to narrow. Investors have started to pay attention: since mid-July, the equal-weighted approach has outperformed after 18 months of lagging behind.

It is not without risks as the largest firms could continue to exceed the expectations of the market, though we believe the reduction of idiosyncratic risks, reasonable valuation, and expected earnings growth to outweigh these concerns.

Consider equities over high yield

We favour equity markets over high yield bonds in an environment where we are constructive about the overall risk outlook. It is true that US equities, mainly driven by growth stocks, appear quite rich. But given that we prefer value compared to growth and equal weighted vs market capitalisation weighted, broad equities in general and – European equities in particular – do not appear overly rich. In the US, we have seen that high valuations can last longer than anticipated. We think technical conditions are still supportive of equity markets and we see potential for further gains.

At first glance, the carry offered by high yield looks quite attractive, especially since the economic backdrop is not showing any red flags. But given current five-year spread duration, any sizeable market shock risks eroding carry opportunities.

While both US and European equities are still below their highs, US and European high yield investments have marked new highs since August. In summary, given the low spread level, we see less opportunity for a sustained performance boost in high yield compared to equities.