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Image: The Switch to Bonds


The Switch to Bonds

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Our views on equities have been constructive throughout 2023. But in the wake of the bond market selloff in September, we switched from equities to govies.

In this report, we elaborate on the reasons why we believe the bond market selloff has probably reached a floor.

Equities have had a good run in 2023, on the back of the growth resilience and the AI revolution in the US, supporting Tech stocks. Yet, we believe the global economy might now be entering a sharper slowdown, as higher yields and the surge in oil prices hurt consumption. The earnings season is starting, and a cautious guidance from companies is likely to prevail. After the equity market rebound last week, our expected returns in Q4 are now close to zero in the US and in Europe as real bond yields put downward pressure on equity valuations. Also, geopolitical tensions in the Middle East are bullish on the commodity theme, which has the potential to derail the global economy. Higher oil prices act as a tax on the consumer, whose purchasing power has been already squeezed.

Meanwhile, treasuries keep safe haven features, despite the poor shape of public finances in most developed countries. The dramatic surge in geopolitical tensions in the Middle East put a floor on the bond market selloff. Implied volatility in bonds remains nonetheless elevated, as consumer prices released last week in the US were slightly above expectations. This has reignited fears of another rate hike from the Fed before year-end. The market sensitivity to the CPI beat/ miss versus expectations looks nonetheless overstated. The core CPI continued to fall and was in line with expectations. The headline CPI was 10 bp above expectations, i.e. a very marginal beat. From our perspective, the Fed will now stay put, but FOMC members will keep the optionality of a final rate hike in their communication.

We show in the report that investors’ concerns about China’s declining holdings of US treasuries are overdone. Actually, foreign holdings of US Treasuries have increased in the past twelve months, as private sector demand offset official purchases. Meanwhile, the supply of Treasuries is normalizing, after an avalanche of issuance flooded the market in the wake of the debt ceiling deal.

The risk reward is particularly attractive for US Treasuries. First, it would take a very large additional pick-up in yields for the one-year total return of short-dated Treasuries to be negative. In fact, with estimate that the total return of a Treasury bond with a duration of two years would be positive even in the event of the yield curve shifting up by 200bps. Second, the risk-reward is asymmetric. If yields rise by another 100bps, we estimate that the one-year loss for Treasuries/ Bunds with a duration of 10 years would be -3.9% and -5.3%, respectively. Meanwhile, if yields by 100bps, that would translate into a 14.2% gain for Treasuries, and a 12.8% for Bunds.

Week ahead: the earnings season will be the key market mover in the coming weeks. 62 companies listed in the S&P 500 will report earnings this week according to Bloomberg, of which 23 financials. In Europe, 37 companies listed in the STOXX Europe 6000 will report earnings, of which 10 financials. On the macro front, the agenda will be relatively light, though US retail sales for September have the potential to drag bond yields lower if household demand shows signs of decelerating.

Asset classes performance (1 week)

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