By Mark Haefele, Global Wealth Management CIO, UBS AG, Vincent Heaney, Strategist, UBS AG London Branch, Daisy Tseng, Strategist, UBS AG Hong Kong Branch and Jon Gordon, Strategist, UBS AG Hong Kong Branch.
Markets continue to show signs of stabilization as investors appear to have looked past last month’s banking turmoil. On Monday, the VIX index of implied stock volatility was trading at just above 17, the lowest level since January last year, while at the end of last week, the MOVE index of Treasury volatility had fallen to levels prevailing before Silicon Valley Bank (SVB) collapsed. S&P 500 20-day realized volatility was even more subdued at just 12.6%, a level last reached in late November 2021.
The drop in market volatility suggests that investors only envisage a narrow range of outcomes for the economy. In early March, the resilience of the US economy, tight labor market, and sticky inflation prompted concerns about further rate hikes, and market pricing for the terminal federal funds rate hit 5.69%.
But while market expectations for the terminal fed funds rate have dropped by 70 basis points since SVB’s collapse, it is hard to believe that a banking crisis and tighter credit conditions have narrowed the range of possible outcomes, especially to the downside. We expect credit conditions will continue to tighten with a negative impact on growth.
So, as a result, we continue to prefer high-quality bonds over equities and are selective within our equity positioning:
- We have bonded as the most preferred in our global tactical asset allocation as we see current risk-adjusted returns as appealing relative to other asset classes. As well as offering attractive yields, high-quality bonds tend to be resilient in the event of a recession, as credit spread widening tends to be offset to a good degree by falling interest rates.
- Defensive equity sectors should be relatively resilient as economic growth slows. In our global sector strategy, we maintain a preference for consumer staples and utilities. Consumer staples continue to see positive and strengthening relative earnings
- We think the outlook for US equities is challenged amid tighter financial conditions, declining corporate earnings, and relatively high valuations. The S&P 500 forward P/E of 18x is near its highest in about a year and is higher than pre-pandemic levels. Historically, when the S&P 500 has traded above 18x, consensus earnings growth expectations are robust (14% on average) or the 10-year Treasury yield is less than 2%. Today, we expect S&P 500 EPS to contract 5% in 2023 and the 10-year Treasury yield is 3.59%. By contrast, we see low-teens total returns from emerging market stocks over the remainder of the year, powered by strong earnings growth, China’s recovery, and relatively cheap valuations.
China heats up
The Chinese economy expanded at a faster-than-expected clip of +4.5% y/y in the first quarter, outstripping both the consensus forecast (+4.0%) and the prior quarter’s pace (4Q: +2.9%). The recovery was a bit uneven though, with consumption the clear standout amid pent-up demand and supportive base effects. In March, retail sales rose 10.6% y/y, a nearly two-year high, driven by a recovery in catering and auto demand, bouncing from the prior January–February pace of 3.5%, while industrial output grew 3.9% y/y. Fixed asset investment eased to a still resilient 5.1% year-to-date, below expectations and down from a 5.5% pace in the January–February period, with property investment remaining a drag.
Our view: The numbers are in line with our expectation for a strong 1Q growth rebound in China as it decisively dropped its pandemic-era controls and pivoted to reopening. The question for markets is what comes next, and how will rising global headwinds impact the recovery? With policymakers pledging a pro-growth stance, and signs a significant recovery in consumption on pent-up demand and supportive base effects, we think China will surpass its relatively modest 5% growth target this year. Given the consumption-driven recovery we’ve seen, we could see a mid-5% GDP expansion this year. We continue to favor reopening opportunities within Chinese equities and forecast an overall earnings growth of 14% this year. Other ways to position China’s recovery include the Australian dollar, commodities, and select European beneficiaries.