Bond yields bite as Fed mulls next move

Market index returns

Week to date since August 9, 2023 as of August 16, 2023

Market commentary:

With bond yields lurching higher, there were few bright spots across risk assets this week as surprisingly robust economic data, combined with evidence of a hawkish-leaning yet divided U.S. Federal Reserve (Fed), eroded the hard won gains from July’s broad equity market rally. Real Assets were not spared. Losses were led by Natural Resource Equities, where metals and mining names were especially hard-hit. The balance of asset classes trended lower on a similar trajectory. Broadly speaking, Asia ex Japan names underperformed while energy commodity prices fell furthest, followed by industrial metals, as concerns about China’s economy manifested in downward price pressure, impacting virtually all corners of global markets.

Why it matters: In a truly shocking, nearly unforeseen development (cough*totally saw it coming*cough), investors seemed to reach their breaking point this week and can no longer remain complacent about capital market risks. From here, what will separate winners from losers will be the ability to differentiate between signals and noise – a task that has become increasingly challenging for fundamental investors. In our view, seeking to identify the inflection points within trends in global business, economic, and credit cycles can help assess directional risks across asset classes, companies, sectors, and regions. Additionally, screening for opportunity through other lenses, such as cyclical vs. defensive exposures as opposed to the more traditional view of growth vs. value, could also offer valuable insights in today’s environment. We maintain that experienced, well-resourced asset managers with a strong emphasis on process who offer holistic exposure to Liquid Real Assets are best placed to exploit the benefits of this unique asset class – such as diversification, liquidity, and attractive growth potential – available throughout a variety of economic cycles.

Digging deeper: This week, we acknowledge the challenges Fed Chairman Jerome Powell faces as he attempts to chart a safe course for the U.S.S. Economy under less-than-ideal conditions. We then address a rapid rise in longer-dated bond yields and the implications for Real Assets. Finally, we turn to China, where property developers are in trouble (again) and the economic outlook has gone from bad to worse.

Fed steers through heavy fog: Minutes of the most recent FOMC meeting released on Wednesday ratcheted up concerns over price pressures, citing “significant upside risks” to inflation. This was balanced by qualms over commercial real estate, where the committee highlighted the potentially adverse impact on institutions with heavy exposures. The Fed must juggle softer-than-expected Consumer Price Index (CPI) data released last week juxtaposed with a better-than-expected increase in national retail sales (+0.7% in July), a 6.7% surge in housing starts, and evidence of continued labor market tightness (as weekly jobless claims came in short of estimates at just 239k), suggesting inflation could remain sticky. While broader equity markets sold off following the Fed’s release, the probability of a “no hike” scenario has remained north of 80% as of the time of writing (per the CME FedWatch Tool). Market participants will be looking for more insights at Jackson Hole next week.
Rising yields won’t yield: Even in a best-case scenario (where the Fed hits pause), rates look likely to stay higher for longer. Hence, it was up, up, and away for U.S. 10-Year Treasury yields this week, which bounced off 4.00% on August 9th and reached 4.30% on Thursday, nearing pre-GFC (global financial crisis) territory. While these levels were touched in the fall of 2022, corporate credit spreads have come in quite a bit from where they were at that time (late October/early November 2022), with BBB spreads now at 171 bps vs. ~215 bps then and high-yield spreads now at 428 bps vs. ~510 bps then. This is largely the result of more positive economic data and better-than-expected earnings. These conditions represent somewhat of a mixed bag for real assets, as tighter spreads are typically indicative of improving economic conditions, but too much improvement may force the Fed to keep rates higher for longer, driving bond yields upward and pressuring equities (especially the capital-intensive sectors), which then screen less attractively on a risk-adjusted basis. We would caution investors not to let this near-term headwind obscure the intermediate and longer-term positive outlook for real assets.
Can AI turn the tides for tech?: The U.S. Towers were amongst the biggest losers this week as rising yields reduced appetite for growth names while a slower leasing environment (amidst the lingering specter of unknown liabilities from wireless carriers due to issues surrounding legacy lead-sheathed copper cables) also weighed. Despite this near-term pressure, we believe communications may be one area where investors are underestimating the impact of AI. Cellular tower infrastructure is the touchpoint for many devices to the internet backbone, especially where a physical connection is not possible. Depending on the specific application, towers may connect homes, automobiles, and personal communication devices (all of which will eventually have AI applications) to the neural networks or centralized computing power needed to process AI. Steady fundamentals, inorganic growth opportunities, and healthy profit margins continue to provide support for towers globally in the intermediate to long term. Elsewhere, data centers are also likely to see revenue enhancement as increasing AI usage can create additional demand, supporting an already robust medium to longer-term trend.
Blight in the Country Garden: Concerns over the solvency of Chinese property developer Country Garden spiraled into full-blown panic after its missed coupon payments on August 6th, and bond trading was subsequently cut off on August 14th. While the initial default of property giant Evergrande in 2021 (which filed for Chapter 15 bankruptcy in the U.S. on Thursday) was rationalized as a leverage problem, Country Garden may be the first undisputed victim of a legitimate property crisis: buyers do not have confidence that developers will deliver the homes they pre-paid for, so they are no longer purchasing those homes, thereby removing a major source of funding for China’s cash-strapped developers. Listed property stocks and infrastructure companies in Asia were pressured indiscriminately as local markets sank on the news, threatening spillover effects into China’s already-faltering economy.

What we are watching: First, we consider China’s next move as it attempts to resuscitate its recovery. We follow up with some considerations on credit markets as the topic of regional banks comes back into focus. Finally, we take a moment to clock progress on the road to net zero in the form of M&A activity in the energy space before deferring to our DWS Research Institute for some insights into longer-term capital market expectations.

China reacts as economy cracks: As Country Garden teeters on the verge of potential restructuring, a fresh round of economic data has come in worse than expected. Retail sales rose just 2.5% in July (down from 3.1% in June and well short of expectations of 4.5%), and industrial production figures were up just 3.7% on an annualized basis (down from June levels and short of July expectations of 4.4%). Accordingly, the Chinese government is having more trouble pushing its “this is fine…everything is fine” narrative. On Friday, in a surprise move and apparent concession, the People’s Bank of China (PBoC) cut its 1-year lending facility rate to 2.5% (down 15 bps) following a 10 bps cut in June. In response, yield spreads between U.S. and Chinese 10-year bonds widened to their highest levels since 2007, and the yuan has come under renewed pressure as speculation abounds that China will ease further to rescue its economy.
Hey, that’s private!: Concerns over tightening credit conditions have continued to fuel recessionary fears. Renewed pressure on regional banks over the last several weeks has given investors pause as they look to precedent as a guide to what might come next. Historically, strains on banks resulted in reduced lending, which constrained capital availability and drove the cost of debt financing higher. However, this ignores the fact that the credit markets have undergone a significant transformation – private credit has increasingly stepped in to compete with banks as lenders. At the end of 2022, private credit accounted for a whopping $1.4 billion of global assets under management, up from $500 billion in 2015 and on par with the U.S. junk bond market (according to Bloomberg), representing a liquidity lifeline for small and mid-size businesses. Could this time be different? Perhaps. Finally, while there is no doubt commercial real estate financing will be at least somewhat constrained over the intermediate term, we would be remiss if we didn’t point out that REITs have much lower debt levels today than they did entering the GFC and – importantly – a much higher percentage of companies have investment grade ratings and can access the unsecured debt markets at pricing below current mortgage costs.
Capturing new opportunities: This week, we highlight a key development in the energy space, which underscores an expanding opportunity set for real assets. On Wednesday, Occidental Petroleum, a traditional U.S. oil and gas company, agreed to the $1.1 billion purchase of a Canada-based carbon capture company called Carbon Engineering. The goal is to use technology to “capture” carbon in the air and store it underground for use in other commercial applications. While it will likely take more time for the technology to become cost effective enough for a standalone carbon capture project to yield attractive returns, we are encouraged by this development and will be watching for more movement in this space as companies and governments alike seek to put capital to work towards a net zero future.
Check out our long view: Our friends at the DWS Research Institute are back again this week with perspective on inverted yield curves and some more great news for Real Assets. The team’s 10-year annualized forecasts rank expected 10-year returns in listed global infrastructure equities at #3 and U.S. listed infrastructure securities at #2 (second only to UK equities) out of 24 asset classes. U.S. REITs are also forecast to offer competitive returns, tying with U.S. equities and European equities for the #7 spot. Additionally, forecasted returns for all Real Asset categories improved since Q1 23 (particularly for Commodities, which ticked up +70 bps), while global equities forecast worsened slightly. Find out more about our long-term capital market assumptions in the full report located here.

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