Positive outlook for market rates

Authors: Gilles Moëc, Chief Economist; Chris Iggo, Chief Investment Officer, at AXA INVESTMENT MANAGERS

Among the secular themes driving equities, AXA IM highlights:

• The continued impact of policies such as the CHIPS Act and Inflation Reduction Act (IRA)(US) and NextGenEU (Europe).
• Renewable energy
• Environmental efficiency
• Digitalisation of all productive sectors
• Artificial Intelligence
• Deployment of drug development

We expect the three major Western central banks to start their monetary easing cycle synchronised in June. The prospect of widespread interest rate cuts in developed economies remains one of the main drivers of expected market returns. Central banks have stabilised interest rate expectations, which should help contain volatility. Once there are no shocks to economic data, this backdrop should be supportive for carry strategies and a broadening of equity returns relative to recent stock market gains that have been, at times, heavily concentrated in the US technology sector. Looking ahead, we see scope for a more balanced equity market performance by region and sector.

The steepening of the curve should be modest

As central banks cut policy rates, the yield curve for major currencies is likely to evolve gradually. However, for the remainder of 2024, policy moves are expected to be limited, suggesting that long-term bond yields will remain anchored near current levels. If we are right about three rate cuts by the Fed, totalling 75 basis points, spot rates will still be above the current level of 10-year Treasuries by the end of the year. Of course, markets will anticipate additional cuts in 2025 and beyond, so the spread between 10-year and two-year Treasuries could move into positive territory.

In Europe, spot rates are likely to remain well above core government bond yields, with the European Central Bank expected to take the policy rate from 4.0% to 3.25% this year. Again, the short end of the bond market could see lower yields as further easing is anticipated by 2025, but with yields on 10-year German bunds at 2.35% at the moment, it will be difficult for the curve to turn materially positive. It is likely that the kind of mid-cycle rate adjustment expected this year will not be sufficient to generate a huge upward steepening of yield curves, with consequent limited opportunities for aggressive long duration strategies in bond markets.

Cash will be less attractive

Spot rates will then remain somewhat elevated, even with central banks confirming the easing cycle. However, this should be favourable for credit markets, as effective interest rates will fall below prevailing yields on high quality corporate bonds and even further below current yields in the high yield market. The prospect of potentially healthy compound returns in credit should make this asset class more favourable than cash, as interest remuneration will decline. From a total return point of view, investors could assume that credit markets offer medium-term yields close to current coupon levels: between 5% and 6% in the US dollar and sterling markets and between 3.5% and 4.5% in the euro-denominated bond market. Again, assuming no shocks in terms of economic data, high yield bond yields will provide an additional yield of 250-350 basis points.

Perhaps most interesting is what the onset of the easing cycle will mean for equity markets. A steepening of the yield curve, however modest, is often associated with an improvement in the performance of more cyclical sectors and equity markets, as well as further support for financial sector profitability. There is growing evidence that global economic growth may be becoming more balanced. Purchasing managers' survey data suggest that industrial activity in major economies is bottoming out. The rapid decline in producer price inflation over the past year points to healthier supply chains, and recent data from Asia show a marked pick-up in exports. Taiwan's export orders are rising rapidly, driven by semiconductor supply to the United States.

These trends are already being reflected in equity market returns in 2024. Total returns so far this year continue to be dominated by US growth and technology stocks, but over the last month there has been some rotation with markets such as Taiwan, Italy, Germany and the UK outperforming US equities. The gap between growth and value has also narrowed. The evolution of yield and yield curves, combined with stronger cyclical economic data, should help cyclical and more value oriented sectors to perform in the coming quarters. In the US, over the last month, banks and energy stocks have led the way in terms of performance, partially reversing the trend of the last year and a half. Industrials and materials sectors have also performed strongly, supporting the thesis of a cyclical recovery that amplifies stock market returns.

Secular factors support broader-based equity returns

In addition to a more positive cyclical outlook, equity returns will continue to be driven by the strength of secular themes. Automation, renewables, environmental efficiency, digitisation across sectors, artificial intelligence and the roll-out of drug development are among the key ones. The continued impact of policies such as the CHIPS Act and the Inflation Reduction Act (IRA) in the US and the NextGenEU policy framework in Europe provide an important tailwind for many of these themes. The investment supported by these policies and the overall shift towards decarbonisation have long lead times, but it seems clear that positive trends in capital spending are emerging. And capital markets are helping. Green bond issuance continues to rise steadily, while the health of public and private debt markets in general is supportive of these investment themes.

The view of a soft landing in the US, better global cyclical indicators and a more relaxed monetary environment over the next six to 12 months is positive for investors. After valuation adjustments related to the interest rate reset in 2022 and 2023, equity and bond yields could return to near medium-term trends. Indeed, the health of corporate sectors suggests that risk assets (credit and equities) can offer decent returns to investors and there is likely to be more upside potential in areas that have underperformed over the last year: Asian equities, UK, small and mid caps and the more value and cyclical sectors. There are considerable valuation gaps in equities, with a near zero equity risk premium in large cap US equities, but better metrics in European and emerging market equities.