2 / Outlook and changes

This being our quarterly Investment Traffic Light edition, we’ll concentrate on our new 12-months strategic forecasts, formulated in mid-June, other than for Fixed Income where we made a couple of tactical changes in the second half of June.

Overall, our outlook is positive. Investors currently have little reason to complain. There are decent returns on the bond markets and the rate cut cycle has begun in many places – if not, yet, in the United States. On the stock markets, U.S. tech stocks in particular are benefiting from the AI hype, while European companies are experiencing a more classic cyclical upswing. Our core scenario sees potential medium to high single-digit returns – provided geopolitical crises do not escalate, and the AI investment boom doesn’t falter.

2.1 Fixed Income

Our Fixed Income forecasts are based on the expectation that there will be two further interest rate cuts by the European Central Bank (ECB) this year and a first cut by the Fed. Altogether, we expect three cuts from both central banks within our forecasting horizon (June 2025).These cuts should cause a steepening of the yield curve – and the expected additional price increase at the short end makes us prefer this segment. When it comes to corporates, Investment Grade (IG) bonds remain our favorites in Europe, and we find much to interest us in the High Yield (HY) segment in emerging markets (EM). From a tactical point of view we upgraded three categories in Europe in the second half of June as we felt the reaction to the European election was exaggerated. We moved Euro high yield corporate bonds to Neutral and investment grade bonds to positive while Italian bonds relative to Bunds were upgraded to Neutral.

Government Bonds

The DWS base case for the United States remains much the same as before: slowing growth, inflation to continue to trend (slowly) downwards and unemployment to stay at about 4%. As restrictive monetary policy begins to weigh on the economy, demand will slow and cuts will begin: typical dynamics late in the economic cycle. Normalization of the currently inverted 2yr-10yr Treasury yield curve should start in the second half of the year, as rate cuts weigh on front end yields. In the 10yr-30yr segment we expect the curve to steepen. We see the 2yr-5yr segment as the most attractive. Long term we recognize rates will stay higher (for longer), though not higher forever. The curve will slowly trend lower, but this process could speed up if the soft landing for the economy ceases to be soft, and unemployment tops 4.2%.

In the EU our base case is that inflation will remain the main driver of core yields. The path to 2% will determine the pace and extent of ECB rate cuts and the slope of the yield curve. High uncertainty may make the ECB cautious about cutting. It is remarkable that the slope of the yield curve is still inverted even though the ECB has already started to cut rates. Our view remains that this will change over time as further expected cuts materialize. We also believe the ECB will continue to drain excess liquidity and that the ECB balance sheet will shrink further, but we see limited implications for yields, and perhaps none at all. Quantitative tightening might lead to somewhat wider spreads for Italian BTPs vs. German Bunds, for which our 12-month target yield is 2.6% for 10yrs and 2.5% for 2yrs. Any unexpected rise in inflation and more rate hikes is the major risk to this scenario. At the moment the good news for Italy is priced in. We see limited scope for further spread tightening and stick to our forecast of wider spreads over the next 12 months: we do not see further positive growth surprises as the impact of the “super-bonus” for building renovations vanishes and its cost on the government's finances is weighed.

The Bank of Japan, the central bank, has problems of a different kind. It is wary of jeopardizing the slowly returning “inflationary mindset” it has desired for so long and is quite nebulous in its communication. The BoJ wants to see rates rise gradually but has also recently stressed that it wants the market to determine Japanese Government Bond (JGB) rates. We expect two BoJ hikes by June 2025, taking the key interest rate to 0.5%. We judge a neutral rate would be around 1-1.5%. We therefore expect the short and medium part of the curve to move up in price more than the long end during the expected hiking cycle, flattening the curve.

Sovereign rates remain stubbornly high

^{Source: Bloomberg Finance L.P., DWS Investment GmbH as of 7/1/24}

Corporate Bonds

EUR investment grade (IG) Credit has performed strongly in the last couple of months. Economic data and company earnings are underpinning the narrative of a soft landing in which IG credit is the sweet spot within fixed income. The “not too hot, not too cold” economic environment has historically been positive for it. The outlook for EUR IG Credit on a 12-month horizon is still positive but its valuation is not cheap anymore, measured on a credit spread basis. All in yields, however, are close to the highs which makes it still an attractive fixed income asset class, with an attractive gain on the risk-free rate. For EUR high yield (HY), we think the current spread level has become quite tight given the high level of uncertainty about geopolitics and fundamentals for some sectors and issuers. Also, many new issues are coming to the market at rather tight spreads and with weak covenant protection, which could cause more harm in the longer run. Therefore, we see a high risk of a correction in the market coupled with an increase in volatility. On the positive side, a correction should offer more attractive investment opportunities again. We forecast the default rate to move up to 2.75% as more companies suffer in the current macro conditions, amid higher funding costs.

The outlook for USD IG Credit remains supportive on a 12-month horizon even though we see spreads remaining in line with current levels. Technicals should be the bright spot for the asset class over the next year: Fed policy normalization should be a catalyst for investors to move from money markets to longer duration fixed income. Valuations and fundamentals remain neutral factors though we continue to expect more rating upgrades than downgrades. We think the upgrade cycle is running out of steam but we are also not concerned with widespread downgrades given our expectation of a mild recession at worst and balance sheets that are in decent shape. We are neutral on U.S. HY, while continuing to seek opportunities for credit improvement, upgrades, and mergers and acquisitions (M&A) activity. We would expect modest spread decompression and a rise in credit dispersion later in the year. In the near-term U.S. HY is supported by resilient growth, earnings, and improving capital market access.

Credit spreads in Europe and the U.S. still very low

^{Source: Bloomberg Finance L.P., DWS Investment GmbH as of 7/1/24}

Emerging Markets

Looking at Credit Asia, China's latest U-turn in its property policy has provoked a positive change in market sentiment. The Chinese government is now tackling the sluggish property market using tools targeting both supply and demand. China’s economy is still subject to weak demand but relatively healthy institutions, especially technology, media and telecommunication (TMT) names, have been active in the capital market and raising funds successfully. Asia USD bond investors have continued to put money to work in both IG and HY on the back of U.S. rate cut expectations. Life has also returned to the HY market as Indian, Indonesian and Japanese issuers have been able to carry out sizeable issuance in the primary market. Investors are also chasing HY names for yields in the secondary market. The initial public offering (IPO) market has been busy, but pricey too. Net issuance in 2024 is still negative despite a robust primary market. In terms of valuation, we remain positive on Asia credits on the back of technical support, high saving rates, decent corporate balance sheets and, importantly, decent coupon carry. For reduced volatility IG will continue to be preferable to HY.

For the entire sovereign Emerging Market space, we believe an important topic for the 12-month period are U.S. elections and their impact on market sentiment, as well as the potential geopolitical repercussions. We see a chance for a constructive “carry environment” over the next months, with a risk of higher volatility starting towards year-end. Overall, we expect spreads on USD bonds to move sideways in our base case. Various IG names already have tight spreads and we see attractive opportunities among BBB-rated issuers with high spreads in medium and long maturities. IG issuers may benefit more from investors looking for yield than for spread levels. We regard several HY names as attractive, too. EUR-denominated bonds trade with attractive yield for various IG and HY sovereigns. This asset class also benefits from a very solid technical basis amid very low new issuance. Refinancing ability remains key, especially for HY sovereigns. Most IG names have been able to carry on issuing, and some HY issuers have also been able to place new bonds, which is a positive sign. It remains to be seen whether more HY issuance will be possible. Political stability and progress on reforms remains key for HY sovereigns. Spread tightening could be seen for distressed names with spreads above 1,000 bps and defaulted issuers. The index share of such names is above 7%. Thus, idiosyncratic stories could drive spreads unexpectedly – in either direction.

Currencies

The relatively strong U.S. economic outlook and high interest yields favor a strong U.S. dollar not just in 2024, but beyond. Whatever the election result, U.S. trade policy is expected to be protectionist, which should be positive for the Dollar. The increasing intense discussion on the sustainability of U.S. government debt should drive the US yields higher, which is supportive for the Dollar. The Yen remains a funding currency, even though the BoJ is expected to raise its interest rate. Increasingly, too, the Swiss Franc is joining the funding camp. Commodity currencies, such as the Australian Dollar, are being negatively affected by gloom on China sentiment, even though commodity prices are increasing. There is still no reflation of the global economy and therefore EM currencies are still facing challenges. But if the rate-cutting cycle of G7 central banks gains momentum, risk assets should be supported, including EM currencies. Big rate cuts in some EM countries, however, are negative for their currencies, so that as an investment, EM currencies are becoming increasingly idiosyncratic, with careful selection necessary.

2.2 Equities

The Artificial Intelligence (AI) speed train keeps running, but for how much longer? Investors that have missed out on the rally so far might think that the easy money has been made, and so why bother now to enter the market? But that has often been said in the past, too early, to investors’ cost. We believe that despite stretched U.S. valuations, markets are likely to keep going up as long as the so-called magnificent 7 keep delivering earnings and exciting new products. And, for now, we see no sign of this ending. We are lifting our equity targets in line with higher earnings per share (EPS) assumptions. We expect some corrections ahead of the U.S. election as investors increasingly look at how fiscal policy, U.S. debt and Treasury yields will develop under the next president. While it remains to be seen what kind of productivity gains AI will eventually bring the hundreds of billions of dollars now being spent on AI and AI-related investments are real and are pushing up GDP growth and earnings.

In combination, falling inflation, fading recession fears and AI enthusiasm have pushed U.S. stock valuation levels versus bonds towards levels last seen in the late 1990s. We have set our June 2025 S&P 500 index target at 5,600, sticking to our forecast of a price earnings (P/E) ratio of 21.5, based on the last 12 months earnings. This is an equity valuation clearly above the historical relationship with bond yields or a normal level of equity risk premium. To stretch to this level, we are adding a temporary 15% growth premium to the S&P 500 to reflect a 2-3 year expected period of superior earnings growth. For the next 12 months we expect the S&P EPS to progress by 11% towards $261 – in line with consensus – driven by 15-20% earnings growth in the so-called magnificent 7 and around 5% elsewhere. In the mid-term we expect that multiples will have to normalize towards lower levels again.

Outside the U.S., we forecast earnings should also grow at respectable speeds, of approximately 6% in Europe, 9% in Japan and 13% in Emerging Markets (EM). Therefore, we assume that record-high valuations discounts relative to the U.S. will not get any bigger. Our June 2025 target for the Stoxx 600 index is 530, and for the Dax 19,600. We realize that the snap French elections have created political uncertainty in the near term, complicating our continued overweight Europe call. But the move to a populistic government in Italy has not prevented the Italian equity market from outperforming the rest of Europe

Similarly, we believe it still makes sense as a  global investor to hold some equities in EM (neutral) and Japan (neutral). In EM we are avoiding state-owned enterprises and prefer IT and consumer stocks. Japanese companies have seen their competitive position improved by the dual impact of a weaker yen and moderate inflation.

We see two main areas of risk for our base case scenario, market related and external. The market factors are: valuations could return to their mean; the first Fed cut could trigger sector and style rotation; profit margins could be stretched and AI-fatigue set in. The external factors are: the U.S. elections; irresponsible fiscal expansion which could cause higher sovereign yields; war and rising import tariffs; and challenged consumers. 

We would add a further observation. As fundamental equity investors we believe in two principles – equity prices follow earnings, and portfolios should benefit from diversification. The first principle offers encouragement, as earnings are good, while the second has become more of a headache for many portfolio managers.

• In the long-run equity prices will follow the progress of EPS. Recent quarters have shown that earnings are growing again globally, providing rational support for rising equity markets. Even more important for long-term investors is that the S&P earnings growth rate has exceeded the U.S. consumer price index by a factor of almost four over the past three decades, supporting the notion that equities offer structurally good inflation protection to portfolios.
• A second fundamental investment principle states that increasing portfolio diversification should result in higher risk-adjusted returns. This principle is so widely accepted that U.S. ERISA rules (the 5/25 rule) and European UCITS regulations (the 5/10/40 rule) have explicitly limited single stock concentration in mutual funds. However, the ongoing outperformance of mega-large caps like the Magnificent 7 has forced many benchmark-driven portfolio managers to give up on their diversification rules in order not to fall even further behind stock benchmarks. This is resulting in ever more concentrated, correlated and potentially riskier equity portfolios. The short-term reality for many portfolio managers is effectively that there is a bear market – for diversification. This current market anomaly should revert – eventually.

We continue to believe in the long-run benefits of portfolio diversification. Within the portfolio context, we overweight Europe, as earnings keep growing across sectors, the economy should accelerate and valuations are attractive, with an average 35% discount to the S&P 500, especially for small caps now facing less headwinds from rising interest rates. Our preferred sectors are Communication, which offers AI exposure at a reasonable price for double-digit EPS growth, and discretionary consumption, which is benefiting from healthy labor markets. In terms of investment style, we stick to our cyclical bias as we believe it is too early to go for a defensive overweight. The expected Fed cuts should support consumer and capex spending.

Shareholders have little reason to complain – S&P ahead thanks to tech

^{Source: Bloomberg Finance L.P., DWS Investment GmbH as of 7/1/24. Chart shows index price return.}

2.3 Alternatives

Real Estate

United States: Real estate prices have bottomed in our view. Appraisal-based values are lagging, but we believe they will return to growth in the second half of 2024. We believe interest rates have peaked, removing a significant headwind from real estate valuations. Over time, modest interest rate relief could act as a tailwind. In our view, a new cycle is coming into view, characterized by improving valuations and strong fundamentals, aided by low levels of new supply. We believe that underlying fundamentals will drive greater dispersion in performance, favoring the industrial, residential, and retail sectors, and markets in the Sun Belt and Mountain West.

Europe: Occupier fundamentals look strong, especially given the collapse in development activity over the past two years, which suggests supply shortages will only continue to mount over the coming two to three years. We continue to favor residential and logistics, with both already showing the first signs of recovery. However, we also expect rapid growth in interest in emerging niche sectors, in particular data centers. Current market conditions are attractive for value-add strategies: significant valuation declines for non-prime properties; a lack of capital to inject the equity necessary to de-lever and refinance loans; regulatory requirements accelerating obsolescence; and increasing undersupply as new construction is falling.

Asia Pacific: We believe the real estate repricing cycle in Asia Pacific could bottom by the end of 2024, coinciding with an easing in financing conditions by year-end. Our house investment themes include Repriced Logistics and Built-to-Rent/Multifamily across Australia and Japan, underpinned by structural growth drivers, as well as tactical opportunities such as Sydney Office, High-street Retail in Japan and Structured Equity & Debt opportunities. Investors may also consider regional value-add opportunities such as asset repositioning strategies, while selective investments in higher risk operational real estate and emerging markets could drive higher returns.

Infrastructure

Full-year 2023 performance shows the strength of the asset class in dealing with macro pressures. There has been no market-wide repricing and strong total returns have been recorded. There has been downward pressure on valuations in sectors reliant on high capital expenditure, because of the higher rate environment. The fundamental policy environment remains positive, however. Our preference is for Europe which has more developed demand-side policies for numerous energy transition sectors. Fundraising has picked up, but the failure of the transaction market to recover rapidly has seen liquidity in the market suffer. Rate cuts should see some building of momentum.

Private debt: The outlook for 2024 remains positive. After a drop in Private Equity-driven transaction volume this year, the market is expected to recover in 2024, supported by an expected narrowing of the valuation gap and significant dry powder on the direct lending and sponsor side that needs to be invested, with an additional impulse from expected ECB rate cuts​.

Gold

Gold has continued to perform well, boosted by persistent geopolitical turmoil, rising fiscal deficits, and strong purchases by both central banks and retail investors in Asia. Rising deficits necessitate easy monetary policy, which, coupled with de-dollarization driven demand from central banks, could see gold reach $2,600/oz in 2025.

Oil

Near term we believe oil will continue trading in a volatile sideways pattern. Uncertainty stems from both the macro-economic and geopolitical fronts. Given ample supplies, which will gradually increase further from October as a result of a recent OPEC meeting, crude prices should remain under pressure, unless there is stronger demand. In the medium term we expect a recovery in global demand to begin to match the supply additions, which should result in crude oil prices recovering, incentivizing investments in additional production capacity. We see elevated production growth out of the U.S. moderating in 2024 as the shale boom comes to an end. The difficult dynamics relating to the sanctioned oil producers, Iran and Venezuela, creates additional uncertainty regarding future oil supply from these two swing producers. Our 12-month target for Brent crude is USD 80/barrel.

Despite geopolitical tensions, oil remains range-bound while gold stabilized lately

^{Source: Bloomberg Finance L.P., DWS Investment GmbH as of 7/1/24}

2.4 ESG

For EU carbon allowances this wasn’t a very good winter. The weather was warmer, windier and wetter than usual which, in combination with economic weakness, led to declining Emission Trading scheme (ETS) prices in the first two months of the year. They have recovered since from EUR 50 to EUR 65 and we believe they will reach EUR 80 per ton again within 12 months. From a medium to long-term point of view we believe prospects continue to look strong as the carbon border tax will start in 2026, the EU proposed tougher 2040 carbon targets and as the emission caps continue to decline.

3 / Past performance of major financial assets

Total return of major financial assets year-to-date and past month

4 / Tactical and strategic signals

The following exhibit depicts our short-term and long-term positioning.

4.4 Legend