Financial markets have encountered significant volatility over the last few weeks as investors digested a flurry of impactful events and information. The attempt on former U.S. president Donald Trump’s life and President Biden’s withdrawal from the presidential race shifted perceived election odds and its implications for taxes, regulation, trade, immigration and foreign policy.
Later in July, the deaths of several senior members of Hezbollah and Hamas intensified geopolitical tensions and threatened further escalation in the Middle East. The Bank of Japan’s (BOJ) decision to raise interest rates and taper its bond buying program on July 31st set off an unwind of the carry trade, a strategy that takes advantage of the interest rate divergence between Japan and other regions.
In the subsequent days, investors became increasingly concerned about the outlook for economic growth as purchasing managers indices (PMI) declined in most major regions (Exhibit 1). Moreover, surprisingly weak U.S. jobs data further rankled markets as the pace of the recent rise in the unemployment rate, even if from a low base, triggered an efficacious recession indicator known as the Sahm Rule.
Exhibit 1: Global purchasing managers' indices
Note: As of July 31, 2024. Source: Macrobond, RBC GAM
Although the economy has slowed, the data continues to favour economic growth over recession. The U.S. economy remains robust with a still-healthy labour market and solid consumer spending. In fact, since the spike in market volatility in the first few days of August, economic data prints such as the ISM Services PMI and weekly jobless claims beat estimates and helped to temper investor concerns that the economy could be headed for a downturn.
In addition, the BOJ’s deputy governor Uchida assured that the central bank would not raise rates when the markets are unstable. After considering all of these developments, our base case continues to be for a soft landing with modest global economic growth and inflation slowing towards central
bank targets.
Sovereign bonds move closer to fair value with recent fall in yields
Global sovereign bonds have delivered terrific returns since late-April as inflation reestablished its downward trajectory and economic data moderated. The pace of the decline in yields accelerated in recent weeks as investors adjusted their recession probabilities higher in response to the weak ISM Manufacturing PMI and payroll reports. The U.S. 10-year yield has fallen 91 basis points in recent weeks, from a high of 4.70% on April 25th to a low of 3.79% on August 5th.
Exhibit 2: U.S. 10-year T-Bond yield
Equilibrium range
Note: As of August 14, 2024. Source: RBC GAM
As a result, the especially attractive valuations in bonds that existed earlier in the year have normalized and our model, adjusted for positive real interest rates going forward, suggests that the current yield is appropriate, sitting near the middle of the 3.3% to 4.5% range projected over the next 12 months (Exhibit 2). This equilibrium range reflects expectations for the gradual decline of inflation towards our target, interest rate cuts and a soft landing for the economy over the period. In our view, sovereign bond investors are likely to earn low- to mid single digit total returns over the next 12 months.
Closing out slight bond overweight and shifting asset mix to a neutral stance
Considering the balance of risks and opportunities in the shorter- and longer-term horizons, we are removing our slight preference for bonds over cash and shifting our asset mix to a neutral setting. The recent rally in bonds reflects a somewhat aggressive central bank easing cycle and has tempered our outlook for bonds going forward as our model indicates a less obvious case for a meaningful downward adjustment in yields from here, absent a downturn in the economy.
Accordingly, we have closed out our slight overweight in bonds of 0.5% with the proceeds going to cash. We continue to expect stocks to outperform bonds over the longer term, but demanding valuations, specifically in U.S. large-cap stocks, and the diminished risk premium over bonds has kept us from adding to our current neutral allocation to equities (Exhibit 3).
Exhibit 3: S&P 500 earnings yield
12-month trailing earnings/index level
Note: As of August 9, 2024. Source: RBC GAM
We would be more inclined to boost our allocation to equities if we saw a durable rotation in equity-market leadership outside of U.S. mega-cap technology and into smaller market cap, value, international and/or emerging market equities. Our current recommended asset mix for a global balanced investor is 60.0% equities (strategic: “neutral”: 60%), 38.0% bonds (strategic “neutral”: 38%) and 2.0% in cash (Exhibit 4).
Exhibit 4: Recommended asset mix
RBC GAM Investment Strategy Committee
Note: As of August 14, 2024. Source: RBC GAM