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We see regional stock markets facing diverse policy, inflation, and growth prospects – affecting corporate earnings. That variety is reflected in the wide dispersion in excess compensation investors receive for the risk of holding stocks over bonds – or earnings yield minus bond yield – in different Developed Markets (DMs). That divergence creates opportunities to be selective, in our view.
The excess yield is compressed in the U.S. (dark orange line in the chart below). We remain underweight U.S. stocks – still our largest portfolio allocation – on a six-to-12-month, tactical horizon. We get exposure to the tech sector, which has outperformed the broader U.S. stock market, through an overweight to the artificial intelligence (AI) theme in DM stocks. The compensation is higher for the U.K. (green line), but we see diminished growth prospects there. We’re neutral U.K. stocks. The excess yield is slightly higher for Japan (yellow line) where we are overweight.
Ten-year Treasury yields saw their largest weekly drop in a year last week. We went neutral long-term Treasuries last month because we saw equal odds of Treasury yields swinging in either direction after their surge to 16-year highs. That two-way volatility is playing out now in large daily moves – and yields are still sharply higher since the start of the year. U.S equities have bounced up after a stretch of losses – even when stripping out the impact of the largest public companies. Higher valuations have pinched the earnings yield gap over higher bond yields. Yet U.S. corporate earnings growth has sputtered in the past year as economic activity has broadly slowed. We stay cautious on DM stocks. U.S. Q3 corporate earnings have slightly beat muted expectations on modest revenue growth, pointing to an expansion of profit margins. But we think higher interest rates and financing costs will crunch earnings and profit margins.
We assess what’s in the price for both stocks and bonds in other DM markets. We recently went overweight euro area government bonds and U.K. gilts to lock in higher yields as markets price in rates staying higher than even we expect. We stay underweight euro area stocks: Even with attractive valuations versus U.S. stocks, expectations for high single-digit earnings growth over the next year look too rosy to us. Euro area corporate margins face pressure from higher rates and slower global growth. We upgraded U.K. stocks to neutral in July and stay there as attractive valuations better reflect the weak growth outlook and hit from rate hikes. Yet we don’t see a catalyst for turning more positive.
We’re underweight Japanese government bonds. We see their yields rising further: The Bank of Japan took a step away from its ultra-loose monetary policy last week when it loosened the cap on 10-year yields even while reserving the option to intervene if yields rise too fast by making 1.0% the “reference rate.” We still see a supportive backdrop for Japanese corporate earnings and stocks thanks to stronger growth and reduced policy uncertainty. We stay overweight after upgrading them from neutral in July. Corporate reforms such as bigger share buybacks and dividends are also shareholder friendly.
Markets are starting to price in the volatile new regime of higher rates and lower long-term growth. We see greater dispersion – and opportunities – as a result. DM stocks are the major building block of portfolios. We get selective across regions based on valuations, earnings prospects, and what’s in the price. We’re overweight short-term Treasuries and recently upgraded long-term bonds to neutral. We are also overweight euro area government bonds and U.K. gilts.
U.S. stocks jumped 6% this week on the drop in long-term yields. Ten-year U.S. Treasury yields fell around 0.3 percentage points this week – the largest weekly drop in a year – and are nearly 0.5 percentage points below the 16-year high hit last month. We think these sharp yield swings reflect the more two-way risk for bonds as the Fed nears the peak in policy rates. While data revealing slowing wage growth is a step in the right direction, we don’t see in rate cuts until later next year.
Jean Boivin is Managing Director, Head of the BlackRock Investment Institute at BlackRock Inc.
Alex Brazier is Managing Director, Deputy Head of the BlackRock Investment Institute at BlackRock Inc.
Wei Li, Global Chief Investment Strategist – BlackRock Investment Institute, and Ben Powell, Chief Investment Strategist for APAC – BlackRock Investment Institute, contributed to this article.
Disclaimer
This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the date indicated and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any of these views will come to pass. Reliance upon information in this post is at the sole discretion of the reader.
© 2023 BlackRock Inc. All rights reserved. iSHARES and BLACKROCK are registered trademarks of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. This article first appeared November 6, 2023, on the BlackRock website. Used with permission.
Image: iStock.com/Bet_Noire
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