Thought of the day

What happened?

A combination of disappointing mega-cap tech earnings and higher bond yields weighed on equities on Wednesday. The S&P 500 fell 1.4% and the tech-heavy Nasdaq ended the day 2.4% lower. The decline was broad-based with nearly 75% of S&P 500 constituents falling. The index has now dropped by almost 9% since its July peak.

  • The average 1-day move for the "Magnificent Seven" was –3.4% on Wednesday. The "Magnificent Seven" account for some of the heaviest-weighted constituents within the S&P 500 index, and their earnings announcements this week have been mixed. Alphabet was the largest faller in the S&P 500 (–9.6%), as markets responded to its management's comments about unpredictable customer spending intentions. Concerns over similar pressures flowing through to other companies weighed on many S&P 500 stocks, including Amazon (–5.6%). Meanwhile, Microsoft was among the top 10 gainers on the day (+3.1%) following its quarterly report, which showed solid beats, led by upside to revenues and margins, expense control, market share gains in its cloud business, and strong bookings. Following Wednesday's market close, Meta’s earnings beat analysts' expectations, taking the stock up 3% in aftermarket trading.
  • Recent data continue to point to a resilient US economy. The September new home sales report was stronger than anticipated, with a rise of 12.3% in sales over last month to the highest level achieved in 2023. But prices declined, with the median sales price falling 12.3% year-over-year—the largest percentage drop since February 2009.
  • US Treasury yields rose ahead of third-quarter GDP data. Longer-dated US Treasury yields rose faster than shorter-dated US yields on Wednesday: The 10-year US Treasury yield increased 14 basis points to 4.96%, and the 2-year US Treasury yield rose 5 basis points to 5.14%. The strong new home sales report and a weak Treasury auction helped push Treasury yields higher. Markets remain concerned that continued economic strength could mean rates will remain higher for longer. The third-quarter GDP report will be released Thursday. The Atlanta Fed's latest GDPNow estimate for annualized real GDP growth in third quarter of 2023 is 5.4%.
  • Markets took little comfort from the election of Mike Johnson as the new Speaker of the House of Representatives, given that a government shutdown after 17 November remains a possibility.

What do we think?

On earnings, while some mega-cap tech companies have disappointed, the results thus far support our view of a bottoming in EPS growth. More than 80% of the companies that have reported have exceeded earnings expectations, and the blended earnings growth expectation for 3Q23 is now +1.22% for the S&P 500, up from near zero at the start of the quarter (and from +0.78% on Tuesday). However, this may be at the expense of earnings growth in the fourth quarter. FactSet shows 4Q23 earnings growth is expected to be 6.3%, compared to 6.8% before the 3Q23 earnings season began.

In our view, the outlook for Treasury yields will ultimately depend on the growth trajectory of the US economy. Much of the momentum behind the rapid increase in Treasury yields has been due to technical factors that should abate. Notably, the Federal Reserve’s shift from quantitative easing to quantitative tightening has removed a significant source of buying, while issuance is trending higher due to the increasing US budget deficit. However, if this trend were to persist, we would expect action from the Fed to preserve financial stability by ensuring the proper functioning of the Treasury market. As a result, we expect economic fundamentals to reassert themselves. Regardless of whether the landing is ultimately hard or soft, we think US and global economic activity will slow and inflation will moderate over the next year—boosting demand for high-quality bonds

We acknowledge we are in a period of heightened concern about the US fiscal situation, but with the new House Speaker, budget negotiations will resume between the House and the Senate. While the 17 November deadline for a government shutdown is fast approaching, we believe the most likely outcome is the adoption of another Continuing Resolution through the new year.

How do we invest?

We have been advising investors to brace for choppy and rangebound trading amid continued uncertainty over the course of Fed policy. Recent mixed economic data have underlined this view and have left the market finely balanced over whether the Fed will hike again.

Against this uncertain backdrop, we remain neutral on equities and favor adding exposure mostly to parts of the market that have lagged so far in 2023—including the equal-weighted S&P 500, value, and emerging markets. We reaffirm our preference for high-quality fixed income on the expectation of slowing economic growth into year-end and into 2024. We foresee further cooling in inflation and slower global growth, and recommend investors consider buying high-quality bonds in the 7–10-year maturity range. Our June 2024 forecast for the 10-year US Treasury yield is 3.5% in a base case, 5% in an upside scenario, and 2.75% in a downside scenario that includes a US recession.

This is also an opportune moment to add to diversified balanced portfolios, in our view. Despite near-term risks for equity markets, we are at a rare time when in our base case, as we expect cash, bonds, stocks, and alternatives to all deliver reasonable returns over the next six to 12 months and the longer term. In our view, investors can tap into an attractive opportunity set across asset classes, position for durable returns for years to come, and mitigate the effect of potential risks.