Within equities, given recent selling pressure on the tech sector, CIO thinks investors considering adding exposure can look to beaten-down AI beneficiaries, such as select global semiconductor stocks. (UBS)

The equity gain was broad-based across size and style. Small-caps outperformed large-caps, and a number of US equity indices achieved gains near 2%. On average, the “Magnificent 7” rose 1.8%, while the S&P 500 increased 1.9% to 4,318, as 89% of the index's constituents ended the day higher.


Meanwhile, the 10-year US Treasury yield declined 10 basis points to 4.66%. Ten-year US Treasury yields have made a rapid descent since 23 October, when the yield last broke above 5.0%. Lower rates provide relief for equities in a slowing economic environment. Since Tuesday’s close, fed funds futures markets have moved to price in 75bps of cuts by the end of 2024, up from 50bps.


Equities looked set to hold onto gains on Friday, with S&P 500 futures down just 0.1%. This was despite disappointing results from Apple, which gave a sales forecast for the holiday quarter that was below market expectations.


The FOMC remains committed to proceed carefully in its future rate decisions, since the process still has a “long way to go” to get inflation down to 2%. The Fed reiterated that further rate hikes couldn’t be ruled out but noted that “tighter financial conditions” would weigh on the economy.


What do we expect?


Until this week’s rebound, equities had been on the defensive since a 2023 peak in late July. A variety of factors contributed to this weakness, which took the decline in the S&P 500 to over 10% as of last Friday—satisfying the common definition of a correction. More resilient US economic data created a perception that Fed rates would stay higher for longer, with the possibility of a final hike before the end of the cycle. Rising yields on longer-duration Treasuries—driven in part by increasing US government issuance—added a headwind. This increased the relative appeal of risk-free fixed income at a time when other metrics of equity valuation also looked demanding. Finally, third-quarter earnings though positive overall—included some disappointments from the mega-cap tech and growth companies that have been leading the 2023 rally. The S&P’s revival this week has reflected improved sentiment on several fronts.


First, the Fed’s meeting on 1 November added to hopes that an end to the tightening cycle may already have been reached. While the Fed’s decision to refrain from raising rates for a second consecutive meeting had been expected, the tone of the accompanying statement appeared more balanced. Notably, policymakers observed that “tighter financial conditions” would weigh on the economy—reinforcing recent remarks from top officials that higher government bond yields could reduce the need for additional rate increases. Of course, there is a risk that by stressing the tightening of financial conditions, Fed officials could cause them to loosen again as yields fall. Overall, the outcome of the meeting supported our view that rates are near a peak and markets had gone too far in pricing a "higher-for-longer" scenario.


Second, the upward momentum in yields was interrupted by this week’s decision by the US Treasury to slow the growth in issuance of longer-dated bonds. The move came in response to the rise in the yield of 10- and 30-year Treasuries to the highest level since 2007. While the government will still be increasing auctions of longer-duration bonds, it will be doing so at a slower pace—skewing issuance more toward the 2-year and 5-year bonds. While this shift alone would not be sufficient to curb the rise in long-duration yields, it highlighted that policymakers are willing to take action to address risks of an overly rapid rise in rates at the end of the curve. This is consistent with our view that the Fed and Treasury are keen to address problems in the functioning of the Treasury markets, given the knock-on risks to financial stability. Given the prospect of slower economic growth into 2024, we expect the yield on the 10-year US Treasury to fall to 3.5% by June 2024, from 4.68% at present.


Third, while US economic data remain mixed, investors have focused in recent days on signs of cooling. The ISM survey for October fell to 46.7—the weakest reading since July after three months of improving activity. The index has now been below the 50-level denoting contraction since last October. And on Thursday, US labor market data showed productivity advancing by the most in three years, easing concerns of wage-driven inflation. Ongoing claims for unemployment benefits have also risen for six consecutive weeks, suggesting that Americans who lose their jobs are having more difficulty finding new work. Much economic data remains resilient. But we expect growth to slow over the coming months as past Fed hikes weigh more heavily on rate-sensitive sectors such as housing and auto sales. Households are having to grapple with the end of childcare subsidies, the trimming of Medicaid rolls, and the resumption of student loan payments. In addition, we expect savings rates, which are still close to historical lows, to increase as confidence ebbs.


Fourth, the recent fall in yields should support equities in general, and particularly longer-duration assets like growth stocks. This includes the top US tech and growth companies—the so-called Magnificent 7—which have led much of the 2023 rally. This group had come under pressure recently after mixed third-quarter results dented optimism over earnings momentum. Although results have been positive overall, results and guidance from carmaker Tesla and internet firm Alphabet disappointed market forecasts. Most recently, Apple warned on Thursday that holiday sales would likely be below market expectations. However, lower yields reduce the headwind faced by longer-duration equities whose valuations are more reliant on profits further out into the future.


Fifth, the correction in stocks had started to make valuations look more attractive. At the start of the week, the S&P 500 sat at about 17 times 12-month forward earnings. Stripping out the Magnificent 7, this multiple stood closer to 15x. In our view, such multiples looked fairly reasonable considering our base case for a softish economic landing. It is still too early to say if the recent improvement in conditions will be sustained. An overly strong October employment report on Friday could rekindle fear that rates will stay higher for longer. But we do see a positive return outlook for stocks over the coming 6–12 months, supported by a softish landing for the US economy along with our forecast for a 9% rise in earnings per share for S&P 500 companies in 2024.


How do we invest?


We retain our preference for the higher-quality segments of fixed income, given the all-in yields on offer and likely capital appreciation as inflation cools, growth slows, and Fed policy rates peak. We favor high grade (government) and investment grade bonds and are neutral on high yield and emerging market credit.


We hold a neutral view on global equities. While we see upside potential over our forecast horizon—for example, in the US, we expect the S&P 500 to reach 4,500 by June 2024 and 4,700 by December 2024—uncertainty about the monetary policy outlook may keep markets rangebound and choppy for now. We recommend focusing on areas that have underperformed this year’s rally, such as emerging market equities.


Within equities, given recent selling pressure on the tech sector, we think investors considering adding exposure can look to beaten-down AI beneficiaries, such as select global semiconductor stocks. Recent tech results confirmed robust AI infrastructure spending ahead and support our expectation for a sharp recovery in revenue next year. With AI demand broadening, we continue to like mid-cycle tech segments like software and internet: We anticipate new AI-enhanced productivity tools, such as co-pilots or generative design tools, will drive adoption in the coming quarters and boost direct AI revenue.


Overall, we maintain our view that this remains a good environment for investors to start to put money to work in balanced portfolios, with attractive prospective returns across asset classes and diversification benefits from holding a combination of equities, bonds, and alternatives.


Main contributors - Solita Marcelli, Mark Haefele, Vincent Heaney, Christopher Swann, Jennifer Liu, Jon Gordon, Alison Parums


Read the original report: Falling yields support equities, 3 November 2023.