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- The ripple effect of the relentless 10-year treasury yield
Market index returns
Week to date since October 11, 2023 as of October 18, 2023
Index definitions: Global Real Estate = FTSE EPRA/NAREIT Developed Index; Global Infrastructure = Dow Jones Brookfield Global Infrastructure Index; Natural Resource Equities = S&P Global Natural Resources Index; Commodity Futures = Bloomberg Commodity Index; TIPS = Barclays US TIPS Index; Global Equities = MSCI World Index; Real Assets Index = 30% FTSE EPRA/NAREIT Developed Index, 30% Dow Jones Brookfield Global Infrastructure Index; 15% S&P Global Natural Resources Index; 15% Bloomberg Commodity Index, 10% Barclays TIPS Index. Source: Bloomberg, DWS. Past performance is not indicative of future results. It is not possible to invest directly in an index.
Market commentary:
Hindsight has revealed that the end of our prior week review period (October 11th) represented the bottom of a short-lived retreat in 10-year U.S. treasury yields. Following the outbreak of the Hamas-Israel conflict and a brief digestion period, the benchmark yield surged upward, nearing the 5% level (a first since 2007) and touching a psychological nerve for equity investors. Across Real Assets, Commodities and Natural Resource Equities managed gains, led higher by precious metals, agriculture, and energy markets. Global Infrastructure headed modestly lower (along with TIPS), while Global Real Estate securities lagged given their capital-intensive nature and the challenging rate outlook.
Why it matters: Risk assets have found a formidable headwind in higher yields – among the casualties have been higher-multiple names, capital intensive names that have seen borrowing costs rise, and fixed income “proxies” such as utilities that screen less attractively on a relative basis. Looking ahead, we count at least two major factors that could halt the relentless rise in bond yields: a recession and geopolitical shocks. Last week offered a test case of the latter as yields retreated while equity markets and Liquid Real Assets classes bounced off recent lows due to rising geopolitical risks. On the former, despite evidence of economic resilience year-to-date, a slowdown during Q4 is widely anticipated (though the jury is not out on its depth or duration). Under the circumstances, investors would be prudent not to put all their nest eggs in the fixed income basket. Support for a strategic allocation to Liquid Real Assets remains firmly rooted in a strong fundamental investment case that can offer investors diversification, liquidity, and attractive total return potential over the long-term.
Digging deeper: Below, we consider how recent developments have shifted the focus back to inflation and what additional insights the Fed has to offer. We also highlight important developments in China and across Commodities markets that drove and influenced price action this week.
Why it matters: Risk assets have found a formidable headwind in higher yields – among the casualties have been higher-multiple names, capital intensive names that have seen borrowing costs rise, and fixed income “proxies” such as utilities that screen less attractively on a relative basis. Looking ahead, we count at least two major factors that could halt the relentless rise in bond yields: a recession and geopolitical shocks. Last week offered a test case of the latter as yields retreated while equity markets and Liquid Real Assets classes bounced off recent lows due to rising geopolitical risks. On the former, despite evidence of economic resilience year-to-date, a slowdown during Q4 is widely anticipated (though the jury is not out on its depth or duration). Under the circumstances, investors would be prudent not to put all their nest eggs in the fixed income basket. Support for a strategic allocation to Liquid Real Assets remains firmly rooted in a strong fundamental investment case that can offer investors diversification, liquidity, and attractive total return potential over the long-term.
Digging deeper: Below, we consider how recent developments have shifted the focus back to inflation and what additional insights the Fed has to offer. We also highlight important developments in China and across Commodities markets that drove and influenced price action this week.
- Defying gravity: We first follow up on our economic release preview from last week, which painted a far-from-flagging picture of the U.S. economy. U.S. retail sales were up 0.7% in September, higher than expected and representing the 6th consecutive monthly rise. Strong consumer spending is continuing to fuel the U.S. economy and, potentially, inflation. Additionally, U.S. industrial production rose 0.3% in September, up from a revised August print of 0.0%, as manufacturing output remained strong. U.S. housing starts also surprised to the upside, bouncing back strongly after a weak August (7% higher month-on-month), although permits were down 4.4% in September versus August, and data was nuanced at the regional and property type levels. Finally, labor markets remained tight, as evidenced by a downward trend in initial jobless claims. With all economic growth indicators pointing up and to the right despite current policy tightness, inflationary fears flared.
- Powell’s prescient pause: With a fresh round of data underscoring U.S. economic strength, markets turned to U.S. Federal Reserve (Fed) Chairman Jerome Powell to gauge the committee’s reaction. Speaking at the Economic Club of New York on October 19th, Powell reiterated the committee’s steadfast commitment towards taming inflation below its 2% target and that economic growth would most likely need to slow in pursuit of that goal. However, he remained evasive when pressed for specific details on policy direction, acknowledging both the progress made to date and the prevailing risks and characterizing rates at current levels as not too high yet, although “higher interest rates are difficult for everybody”. Powell also acknowledged that the Fed may need to do less in light of the rise in long-dated bond yields, which he attributed less to speculation surrounding future Fed hikes and more to “term premium” – in essence, the compensation investors demand for locking up capital for longer and, therefore, more uncertain period of time. We would add that the volume of debt the Treasury needs to issue due to the lack of fiscal discipline as an aggravating factor.
- Good fortune in the Far East: This week, we break our attention away from the U.S. to focus on several developments in China. For one, China’s third quarter GDP came in at 4.9% year-on-year – a notable deceleration from 6.3% growth in Q2, but faster than many analysts had expected. Despite concerns over its flagging property market, policy intervention may yet prove enough for the Chinese economy to find its footing. Consumers appeared to be drawing confidence, as evidenced by an uptick in retail sales, while industrial production also ticked modestly higher. The good news was also timely, as China played host this week at a summit for its Belt and Road Initiative. Notably, across real assets, listed property stocks in Hong Kong fared better on a relative basis versus peers.
- Caught in the Middle (East): Recent events have spurred volatility in crude markets, given uncertainty over how the conflict in the Middle East might develop and how crude oil could be impacted. For now, it appears that the current risk premium will remain until the situation normalizes. In other news, according to Reuters, the U.S. is getting closer to an agreement with Venezuela for at least one other company to take Venezuelan crude as debt repayment, which could potentially lead to higher production growth – a negative development for prices. However, from here, there is a risk that major oil producers, such as Iran, could be sanctioned for their alleged involvement in the Israeli conflict. This would increase the risk premium embedded in prices and would likely prevent crude from correctly reflecting fundamentals. For now, we expect range-bound price action to continue, with macro and headline risks having an outsized influence on prices.
What we are watching: This week, we highlight some key indicators we track and why we’ll be paying more attention to them in the weeks ahead. We then turn to the scary situation in U.S. Congress as a looming deadline gets uncomfortable closer. We also preview some key indicators due out next week that could change everything (or nothing) about the trajectory of markets from here.
- Volatility throws a curve-ball: Volatility (per the VIX Index) began emitting worrisome signals as the VIX futures curve entered a pattern known as backwardation, inverting this week for the first time in about a year as second-month contract prices rose above those of the front-month contract. Since, normally, investors assign an uncertainty premium to contracts further out on the curve, the switch indicates the investors are prioritizing protection in the near-term. While volatility has plagued bond markets more visibly in recent months, it has been relatively subdued across equity markets and has only just started to stir, hovering near the 20-level in an elevated trading range as we write. We’ll be watching this indicator more closely in the coming weeks.
- Higher expectations: Turning to other indicators we track, inflation expectations (as represented by breakeven rates) headed decisively north this week. After lifting off from recent lows on October 5th, the 5-year breakeven rose +20 bps to 2.36% at our period’s end on October 18th and has since risen another +10 bps through October 20th to converge with the 10-year rate. The more recent move may have been fueled by evidence from the Fed in its Beige Book release on October 18th, which highlighted expectations for inflation to persist in October (due, in part, to higher energy/fuel costs and upward pressure on wages). We will be watching this indicator closely as we consider whether (and when) the Fed will tighten again.
- A haunted House?: We return this week to the frustrating topic of the U.S. House of Representatives, which may very well be cursed (it is, after all, very close to Halloween). Republican leaders have failed to rally around the latest candidate for speaker, Jim Jordan, for whom three times was most definitely not a charm as he lost his third House speaker vote. In the spirit of the season, we find it appropriate to “boo”. Hardline Republican holdouts and Democrats alike bear responsibility for finding a real path forward as fears of a shutdown inch closer to reality. The looming spectre of the deadline on November 17th is pressuring the committee to do something as support for Israel, Ukraine, and Taiwan hangs in the balance, along with pressing domestic issues such as border protection. We are hoping we can rely on more than “hocus POTUS” by the time we release our next weekly issue.
- A pivotal moment for GDP and PCE: Next week, we’ll be looking forward to several key data releases, including S&P flash PMI data, third quarter Gross Domestic Product (GDP), and an end-of-week look at Personal Consumption Expenditure (PCE) data for September. U.S. GDP is forecast at 4.5% for the third quarter, up from 2.1% in Q2, while year-on-year PCE is expected to decelerate slightly to 3.7%, down from 3.9% the month prior. Any major disconnect between reality and expectations for these two important indicators could prompt a significant reaction from markets and a change in the calculus of what the Fed might do next.
