Equities and bonds rallied, is the market at a turning point?

2023 has seen rapid shifts in market regimes – from soft landing, to hard landing, to no landing. Over the last week, spurred on by renewed signs of disinflation in the U.S., the soft-landing narrative is back in the driving seat. Both equities and bonds rallied, while the USD weakened. At the same time, the narrative around China’s growth is finally starting to improve. Geopolitical tensions have eased (at least for now), even as they continue to linger. So are markets now at a turning point? And if so – will the rest of the world have a window of opportunity to finally outperform the U.S.?

From a fundamental perspective, we continue to believe that the U.S. economy will likely slow into next year but avoid a recession. The economy should gradually soften, and the Fed will be in a position to lower interest rates by 2H 2024. The U.S. Dollar could be supported in the near-term by U.S. economic resilience, but that should likely ease from its highly overvalued position over the next 12 months. Meanwhile in China, economic data, while mixed, has been stabilizing for a few months as policies are turning more growth supportive. Financial stability risks, such as those stemming from local governments, or the property sector, are now being tackled in a more determined manner.

Therefore, some of the rallies across markets over the last few weeks are justified, in our view. To a large degree, the market is recovering from fears of a more hawkish Fed. As that fear fades, both equities and fixed income are rallying. The decline in U.S. yields and the dollar has spurred a rally outside the U.S. especially in emerging markets. Economic stabilization, and a more constructive turn in China’s policy direction, also merit better market performance; we could see Chinese equities trading closer to the top end of our 12 months outlook range (MSCI China 65-67) as bearish sentiment fades. There is also helpful seasonality in play – particularly for the RMB, given that exporters tend to sell USD around year end.

But it’s important to remember that we have had a few regimes shifts this year. Market sentiment can shift quickly on the back of a change in tone from the Fed, or firmer economic data that pushes out the timing of any Fed cuts. Geopolitical conflicts are still ongoing, and the busy election calendar in 2024 adds another layer of uncertainty. For the China market, stabilization in growth momentum and more counter-cyclical support is only one part of the story. But headwinds remain. Many investors continue to take a dim view of the policy direction. China’s policymakers may take the window of lower U.S. yields to opportunistically ease monetary policy, which could keep downward pressure on the RMB.

Our advice for clients is to stay invested, but also take the opportunities to hedge and diversify in a way that fits with your long-term objectives. We continue to like U.S. equities, particularly the S&P 500, with a focus on technology, industrials, and healthcare. Core fixed income is still our top recommendation. In our view, cash yields have likely peaked and the window to step out of cash and lock in yield is starting to narrow. The curve is reasonably flat, so it makes sense to go a bit further out on the curve (but still within benchmark duration). The USD is in the process of peaking under a confluence of U.S. economic resilience and Fed expectations but will ultimately ease from its over-valued position. For the Asia region, this is a constructive backdrop but not without challenges. We think Chinese equities will likely stay range bound in the near-term, until investor sentiment improves in a meaningful way. Other regional markets such as India, Korea, and Taiwan could further outperform. The RMB could trade strong in the near-term on the back of broad dollar weakness, but fundamentals still point to weakness over the medium term given carry disadvantage and balance of payment challenges.

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