Gloomy outlook unsettles investors

Long-term interest rates are experiencing a significant increase, which could trigger additional economic downside risks. A gloomy outlook from some companies is leading to heightened volatility, but it also presents opportunities in the stock market.

The rise in yields on long-term US government bonds, known as 'Bear Steepening', threatens the expected 'soft landing' of the economy, as it leads to further tightening of the already restrictive monetary policy. Although the yield curve is still inverted (with the yield on two-year Treasury-Notes remaining above the equivalent with a ten-year maturity), the extremely rapid increase in the yield on 10-year Treasury-Notes has reduced the yield spread versus 2-year Treasury-Notes from -1.1% at the middle of the year to now only -0.2%.

The specific reasons for this development are contentious. Long-term yields have certainly risen due to surprisingly positive economic data in the US, with GDP growing by 4.9% in the third quarter. Hence, economic growth significantly surpassed the expectations of most observers, including central bank policymakers. However, there are also negative factors driving yields higher such as the doubling of the US deficit by adding an additional trillion USD compared to the previous year. Furthermore, the rising issuance of bonds to cover an ever-increasing pile of debt causes investors to demand a higher premium to carry the risk associated with long-term bonds.

It's evident that rising costs are tightening financial conditions for mortgages and loans, leading to less investment and a subsequent decline in economic momentum. The negative shift in money supply confirms this trend: money has a challenging price again, and it will likely stay this way for the foreseeable future.

In the corporate world, this new reality is increasingly evident. While recent quarterly earnings results mostly exceeded analysts' expectations, a gloomy outlook has, in some cases, led to significant stock price declines. Alongside rising costs, especially affecting debt-fueled business models, a significant warning of declining consumer demand has been another reason for a currently disappointing earnings season.

Despite these challenges, the global stock market has still shown substantial gains since the beginning of the year. However, it is widely known that a few heavyweight companies in the technology and communications sector have significantly distorted the overall returns. When considering an equal-weighted view, the same index has experienced a loss since the beginning of the year. Particularly, small caps, which often act as precursors for the general stock market, are performing poorly this year and posting high losses year-to-date.

It's worth noting that currently more than 70% of companies in the S&P 500 are trading below their 200-day moving average. However, this situation also presents opportunities. Investor sentiment is as negative as it was during the turbulent May of 2022. Our factor model's contrarian risk index is signaling a counter-cyclical buy signal for the first time in a long while. Therefore, we are increasing our exposure to equities at the expense of liquidity, which leads to a neutral allocation of the asset class. In this market environment, it's highly recommended to continue focusing on quality and avoid substantially leveraged companies, as they are likely to face a significant increase in interest costs in the coming months. Due to the higher volatility in the stock market, we recommend a gradual increase in the equity allocation. Our preference remains with quality stocks offering attractive dividend yields, healthcare, and the energy sector. Overall, fundamental valuation levels are also coming back to the forefront in stock selection.