By Fabiana Fedeli, CIO, Equities, Multi-Asset and Sustainability, M&G Investments
If we needed another reminder that nothing should be taken for granted in markets, we got one during the third quarter of 2024; weakening activity and labour data in the US over the summer, two assassination attempts on a presidential candidate, a last-minute change in the US Democratic Party’s nominee, an increase of the policy rate to 0.25% by the Bank of Japan (BOJ) – clearly signalling a change in direction from its ultra loose policy stance – and rate cuts by all three major developed market central banks, including a much discussed 50 basis point (bps) cut by the Federal Reserve (Fed). To close the quarter, China surprised with a set of coordinated stimulus measures reminiscent of Mario Draghi’s ‘’Whatever it takes” commitment during the 2012 Euro crisis when he was European Central Bank (ECB) President. And, at the time of writing, the conflict in the Middle East has meaningfully escalated.
Markets have responded with a significant increase in volatility. In Japan, we witnessed the biggest three-day equity drawdown in the market’s history. The short-lived volatility spike that ensued, was only exceeded on two occasions in the last 50 years – The Crash of 1987 and The Lehman Brothers’ Crash in 20081. The near unprecedented drop followed a de facto 15bps rate hike that had been fairly consistently flagged by the BOJ since December 2022, and the episode reversed almost as quickly as it happened. By the end of August, Japanese equities had recovered most of their losses in local currency, and were up in US dollar terms over the month2.
Elsewhere, during the July/August volatility, fixed income markets staged a period of outperformance versus equities, with correlation between the two squarely back in the negative camp. Equities experienced a technology-driven set-back, despite a relatively solid reporting season.
The function of the market reaction to the geopolitical events and macroeconomic datapoints was far from straightforward, and unlikely to be predicted based on commonly-accepted market “truths”. In the US, we saw a counter-intuitive reaction to the Fed’s 50bps rate cut, with the short end of the yield curve mostly unmoved, and a sell-off at the long end following the announcement. In equities, Value outperformed Growth, even as bond yields dropped materially3.
There are lessons to be drawn.
The first lesson is to appreciate that history may rhyme, but doesn’t necessarily repeat itself with every related condition just as it was. None of the above reactions would have been surprising if, instead of taking the manual of commonly-believed market rules, market participants had considered the current context.
The pullback in technology came after a strong run, as investors started questioning the Return on Investment (ROI) from all of the AI-related infrastructure spending. Then recession fears started to creep in, resulting in a very low margin for error for the technology companies heading into third-quarter earnings season. Market concerns on future returns trumped any pre-defined positive impact from declining rates on long-duration equities. Actually, the increase in rate cut expectations were driven by the same recession concerns.
And the muted reaction to the Fed’s 50bps cut was driven by bond pricing having already run ahead of the Fed with steep yield declines ahead of the decision.
The second lesson is that we should always invest with the understanding that we don’t hold any undisputed truth, and that we are bound to be surprised, either by events or by the market’s reaction to events. Therefore, we should always put ourselves and our portfolios in the best position to deal with the inevitable balls coming out of left field. When the market turns, portfolio diversification, process flexibility and preparation, with a deep understanding of our investment universe, become essential ingredients. In the following pages, our Equities and Multi Asset investment teams have given some evidence of how the process works in action, talking about the steps they have taken, as the volatility of the third quarter ensued, to generate returns ahead; from buying in Japan and adding to highly cash-generative Chinese stocks to selling US treasuries – particularly at the shorter end of the curve – to adding Northern European banks and high-quality global consumer names that have proven resilient to consumption trends.
As investors, our aim is not to produce precise economic forecasts, but rather – based on our knowledge, perspective and experience – to judge when market participants have taken their macroeconomic or company fundamentals concerns to extremes, and valuations have deviated significantly from what the scenario of future outcomes is likely to be.
It often happens that in periods of uncertainty market participants become exceedingly short term-focused, responding to every new data point and often extrapolating its impact. Such short-termism creates a compelling opportunity for investors who are willing to look beyond near-term volatility. As our Multi Asset team reminds us, and as demonstrated over the summer period, volatility – though scary at the time – can also be a major source of opportunity and returns.
Looking Ahead
In our last Quarterly Equities and Multi Asset Outlook, published in mid-July, we shifted our preference from equities, which we had maintained for a long time, to fixed income. The better risk-reward was driven by the US, after a strong equity market performance, and given modestly weakening domestic data and higher odds of rate cuts.
Since then, US fixed income markets have run hard, pricing in a significant amount of yield decline ahead of the Fed’sSeptember rate decision. This was clear by the muted “after the fact” reaction of the US treasury yield curve to the Fed’s 50bps cut. Since then, yields have been on the rise again.
Going into year end, yields are likely to come down, at the very least in the US, Europe and possibly the UK, but conflicting expectations on inflationary pressures, fiscal policy and the health of the global economy ahead could make the path less straightforward. We are at a juncture where the market is expressing clarity of forecast when there is neither clarity of data nor visibility. Importantly, shifts in rate cut expectations are likely to add intermittent volatility in fixed income far more than in equities. Hence, within our multi asset portfolios, we have now dialled down to a more neutral stance in fixed income versus equities going into year end.
Within fixed income, we shifted some weight from US treasuries to UK gilts and credit, which had not rerated as much as US treasuries and credit. We also continue to like South African bonds which have performed well but likely have some more upside potential, driven by rate cuts. We have kept exposure to the long end of the US treasury curve, where we saw a sell off after the Fed rate cut announcement. The long end should also provide an ‘’insurance’’ role should the macroeconomic picture significantly deteriorate. Importantly, this is a good market environment for tactical asset allocation, responding to short-term market gyrations based on excessive expectations in either direction.
Looking ahead to 2025, US fixed income has the potential to start outperforming again, and regain its diversifying qualities, in an environment where the Fed cuts rates in response to weaker US macroeconomic data and with the backdrop of lower inflation. Such a scenario is probable, but by no means certain. It wouldn’t be the first time that the US economy has defied the odds. And a market where macroeconomic conditions remain resilient, and rates are declining, would support equities.
Importantly, even when fixed income markets have outperformed broader equity markets in the summer, we have learned that there are pockets of equities that can generate much higher returns compared to fixed income markets. Areas of equities that we like are those that have been affected by higher rates, for instance in infrastructure. Admittedly, some pockets have already started to turn around meaningfully, for example utilities. But there are still opportunities, including in long-forgotten areas such as renewables. As always, selection remains important as some of these stocks may be affected by issues other than just rates, such as supply gluts or permanently-weakened balance sheets.
Another area to note is industrials. As we enter the fourth quarter, we believe de-stocking will soon be behind us, and many of our meetings with automation equipment suppliers and truck manufacturers around the globe suggest exactly that. Whatever happens to underlying demand from here, it won’t be compounded by de-stocking and we see opportunities in many beaten-up shorter-cycle stocks.
And then there is the technology and AI-related stocks. This would not be the first time in the last 20 years that instances of significant technology-related market sell-offs turned into buying opportunities for investors. Clearly, not all technology stocks are created equal, but growth and profitability trends remain durable for leading technology companies. Moreover, we believe the AI theme is largely ‘macro agnostic’ as hyperscalers have hundreds of billions of dollars in cash and the ability to invest through economic cycles. In our view, it would take a severe recession to cause these large hyperscalers to adjust their plans. Our Global Thematic Technology investment team sees the growth in AI not as optional but in many ways existential.
While the dispersion in valuations within the US equity market is such that we can still find attractive domestic opportunities, from a regional standpoint, we find more reasonably-valued companies outside of the US equity market, for example the UK, Japan and, within Emerging Markets, Brazil.
We would be remiss if we did not mention China after such a strong run. Following the coordinated stimulus from Chinese authorities, the market has sky-rocketed. At the time of writing, the MSCI China Index is 53% up from this year’s trough4. It would not be surprising if the market were to take a pause in the near term and, for gains to be sustained, we would need to see some clear impact of the stimulus on economic activity and demand. Yet, on a longer-term view, Chinese equities are still below long-term average valuations and, more importantly, we continue to find inexpensive names with high cash generation, being deployed in higher dividends and buybacks.
Market volatility is likely to persist with upcoming elections in the US and an escalating conflict in the Middle East. Higher US import tariffs and geopolitically-linked oil supply bottlenecks could feed into future inflation data and, if not revert, at least stall central banks’ paths to lower rates. Activity and labour data in the US have started to weaken but the path is not straightforward, with some strengthening in the most recent datapoints. For now, a recession does not appear imminent. Nonetheless, we have learnt that jobs data can unravel quickly and, starting with a 50bps rate cut, the Fed must have felt that risks were on the horizon.
Also in Japan, with former defence and agriculture minister, Shigeru Ishiba’s, unexpected win at the end of the quarter to be Japan’s next Prime Minister, we might well expect further volatility.
We remain ready to take advantage of any price dislocations that take valuations below what the long-term outlook would warrant.
Volatile markets can be unsettling and emotionally draining. However, through careful portfolio construction and disciplined fundamental analysis, these instances can create compelling opportunities for investors with a longer-term horizon.
