“Lower for longer” interest rates are back with a bang. On Thursday, yields on the 10-year German government bond fell below the European Central Bank's deposit rate (-0.4%) for the first time. At the 10-year maturity, yields are negative in a further eight European countries: Switzerland, Denmark, the Netherlands, Austria, Finland, France, Belgium and Sweden. The global stock of negative yielding debt stands at a record high USD 13.4trn. In the US, 10-year yields are still positive, but have fallen by 128 basis points since last November’s peak and are back below 2%.
At the same time, equities continue to rally. While the US market was shut on Thursday for the 4 July holiday, S&P 500 futures traded at a record high above 3,000. But this apparently contradictory market behavior can be reconciled:
- Fixed income markets are pricing in pre-emptive central banks rate cuts to stave off the risk of a recession, but also that renewed easing will not generate inflation. June’s dovish shifts by the Federal Reserve and the European Central Bank prompted a bounce in market measures of inflation expectations, but the rise has not proved durable. Eurozone 5y/5y inflation swaps are trading at 1.16%, close to the record low of 1.13%, and 10-year US inflation breakevens have dropped to 1.61%.
- Equity markets are pricing in that rate cuts will succeed in prolonging the economic expansion, with little chance that central banks will need to reverse course to choke off rising inflation.
- Equities remain attractive relative to bonds – with a global equity risk premium of 5.8% compared with a long-term average of 3.5% - and in our base case we expect equities to edge higher. But the first half will be a tough act to follow. Global equities have returned 18% year-to-date and valuations are back above their 20-year average. We think second half returns are likely to be a lot lower than in the first half.
So, against this backdrop of lower rates for longer and more modest expected equity returns, we recommend equity approaches that generate income, like equity-buy write strategies, which work well in sideways to gently rising markets, and focusing on fundamentally strong companies that offer consistent dividend growth. An environment of pre-emptive Fed rate cuts is also likely to support carry trades. In our FX strategy, we overweight a basket of equally weighted high-yielding emerging market currencies (Indonesian rupiah, Indian rupee, South African rand) against a basket of lower-yielding currencies (Australian, New Zealand, and Taiwan dollars). Overall, our 6- to 12-month tactical positioning continues to overweight equities with a regionally selective approach. In the near term, given downside risks, we would also recommend countercyclical positions.
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