Allocating Assets | Prepping your portfolio for 2H23 (7:26)
CIO's Mark Andersen and Adrian Zuercher on tech exposure, currency trades, and managing geopolitical uncertainties.
 

Thought of the day

The S&P 500 moved only 0.2% lower on Wednesday, despite further hawkish signals from the minutes of the Federal Reserve’s June meeting. Policymakers expressed concern over “unacceptably high” inflation, with “almost all” believing that further rate hikes will be necessary this year. Officials added that a “tight” labor market added “upside risks” to inflation.

While the rally in US stocks has stalled this week, the S&P 500 has still gained 15.8% so far in 2023. In our view, that suggests the market is too upbeat about the prospect that the Fed can achieve a soft landing for the US economy, combining a swift decline in inflation with relatively resilient growth.

Risks remain that the Fed could hike more than markets are expecting. Fed futures are implying around 33 basis points of further tightening through the November meeting, with the potential for easing thereafter. The Fed’s dot plot, which charts expectations from policymakers, implies a slightly higher peak in rates of between 5.5% and 5.7%, consistent with 50 basis points of additional tightening. Fed Chair Jerome Powell recently indicated he would not take “moving at consecutive meetings off the table.”

The delayed effects of prior hikes are still feeding through, adding to headwinds for the economy. While the Fed kept rates on hold in June, the 500bps of tightening implemented in just over a year was the swiftest pace of hiking since the 1980s. Combined with the continued hawkish messaging from the Fed, this tightening has been creating more restrictive conditions. This was underlined on Wednesday when the real yield on 5-year US Treasuries closed above 2% for the first time since 2008. The nominal yield on the 10-year Treasury, meanwhile, rose 8bps to 3.93%, the highest level since the collapse of Silicon Valley Bank in early March.

Equity market valuations leave little room for policy error. The US equity market is trading at 19.3 times 12-month projected earnings, a roughly 19% premium to the 15-year average, based on the MSCI USA Index. Such multiples have historically been associated with periods in which 10-year US Treasury yields have been below 2%, rather than close to 4% as at present, and also periods of robust earnings growth. Given that 12-month trailing earnings per share growth has remained above the post-1960 trend rate, we see little potential for a swift bounce—even if the Fed succeeds in guiding the US economy to a soft landing.

So, against this backdrop, we see a better risk-reward outlook for fixed income over equities. In particular, we are most preferred on the higher-quality segment of fixed income, given the attractive all-in yields along with the potential for capital appreciation as investors shift their focus from inflation to growth risks.