With conflicting forces pulling on markets, CIO advises investors to strengthen core multi-asset portfolios. (UBS)

An explosion at a hospital in Gaza caused Palestinian, Egyptian, and Jordanian leaders to cancel meetings with US President Joe Biden.

Instead, yields appeared to be driven by strong US economic data, with retail sales rising 0.6% month-over-month in September—well above the consensus forecast for 0.2%. The release added to worries over the potential for a further rate hike from the Federal Reserve in 2023, along with concerns that borrowing costs will stay higher for longer into 2024.

But, while the 10-year yield has resumed the rise that was interrupted over the past week, we believe yields will decline again. Meanwhile, recent news highlights the appeal of diversified, multi-asset portfolios.

Barring a regional escalation of the war, economic fundamentals will likely remain the main driver of yields. Recent market moves underline this position. The US Treasury market has been taking its lead mostly from economic data and comments from Federal Reserve officials over the outlook for rates, rather than primarily from events in the Middle East. Rather, investors are expressing their changing views on the outlook in the Middle East through other traditional safe-haven assets. Gold hit a one-month high of USD 1,938 an ounce, and is up around 6.5% since 5 October, just prior to the Hamas attack. Brent rose around 2% to USD 91.90, reflecting concern that a broader Middle East conflict could disrupt oil supplies.

Despite continued signs of economic resilience in the US, a slowdown is still on the way and will bring down yields, in our view. Recent data releases, including September retail sales, suggest that excess savings accumulated during the pandemic continue to offset part of the impact of higher interest rates. We don’t expect this to last. First, the impact of prior Fed hikes will eventually weigh on activity in rate-sensitive parts of the economy including the housing market and auto sales. Second, consumers face additional headwinds from the fading of extra government assistance put in place during the pandemic, including childcare subsidies, assistance with healthcare costs, and breaks from student loan payments. Third, US consumers have been saving less than the historical average, and this should eventually return to more sustainable levels.

Top Federal Reserve officials have repeatedly pointed out that rising bond yields may do part of the central bank’s job in cooling growth and bringing down inflation. For example, Fed Vice Chair Philip Jefferson said he would “remain cognizant of the tightening in financial conditions through higher bond yields,” and that he would “keep that in mind” in assessing the future path of policy. Dallas Fed President Lorie Logan made a similar point, saying that higher yields—especially if due to waning risk appetites rather than expectations of strong economic growth—meant “there may be less need to raise the fed funds rate.”

Finally, Minneapolis Fed President Neel Kashkari said it was possible that higher yields would reduce the need for tightening. He cautioned however that “if those higher long-term yields are higher because their expectation about what we’re going to do has changed, then we might actually need to follow through on their expectations in order to maintain those yields.”

So, in our view, concern over the outlook for the Middle East is mostly being reflected in gold and oil. Yields are being mostly driven by economic fundamentals, which we expect to cool. Against this backdrop, we are most preferred on high-quality bonds, which should benefit as growth slows and inflation moderates. However, with conflicting forces pulling on markets we advise investors to strengthen core multi-asset portfolios. We continue to view gold and oil as having a hedging value in portfolios, especially at times of heightened risk.

Main contributors - Solita Marcelli, Mark Haefele, Christopher Swann, Vincent Heaney, Jon Gordon, Matthew Carter, Jennifer Stahmer

Original report - Diversification matters as conflicting forces pull on markets, 18 October 2023.