As global equities generate solid returns this year, we explain where we see potential opportunities for investors, despite the potential for market volatility.
August 24, 2023
By Joseph Wu, CFA
Despite a steep rise in interest rates across many countries over the past year, global growth has maintained an upward trajectory. As the largest economy in the world, the U.S. continues to display resilience. Projections from the Federal Reserve Bank of Atlanta’s GDPNow model suggest U.S. real GDP could expand by over five percent in Q3. Should this forecast hold true, U.S. economic growth would more than double its Q2 rate, marking the fastest pace since Q4 2021. While we think this forecast will almost certainly be revised lower as the quarter progresses, the recent trend of economic data surprising on the upside paints a picture of an economy running stronger than expected. In our view, the following constructive factors that have been propelling the U.S. economy could help extend the growth runway in the near term:
Line chart showing U.S. real (inflation-adjusted) wage growth, calculated as the Atlanta Fed Wage Growth Tracker Overall minus U.S. CPI. Based on this measure, U.S. real wage growth has improved to +2.5% in July, after dipping into negative territory between April 2021 and January 2023.
Source – RBC Wealth Management, Bloomberg; data through 7/31/23
It is now easier to envision a “soft landing” for the U.S. economy, in which monetary policy tightening curbs inflation without inflicting major economic pain. But we think some uncertainties continue to stand out as potential sources of risk.
Lingering upside risks to inflation warrant monitoring, in our view. Price pressures have subsided meaningfully, but various measures of worker compensation growth still seem too high to be consistent with credible expectations of inflation returning to the Fed’s two percent target over the medium term. Core CPI (excluding food and energy) was 4.7 percent y/y in July, while the recent rebound in energy commodity prices serves as a reminder that central banks’ battle with inflation may not be over.
Given that Fed officials continue to reiterate their focus on inflation and a tight labour market, they will likely require more concrete evidence of softened labour demand before concluding that inflation is sustainably converging to their target and monetary policy does not need to tighten further.
We are also mindful of the delayed effects tied to monetary policy adjustments. Persistent economic strength has motivated some to take the view that the U.S. economy is immune to higher interest rates, but we believe the more likely explanation is the “long and variable” lag for monetary policy to be felt in the economy. According to RBC Global Asset Management, each rate hike can deliver a steady headwind to economic activity lasting about 2.5 years.
The possibility that monetary policy may have to remain restrictive for some time (higher rates for longer) or turn even more restrictive (more rate hikes), if Fed officials deem it necessary to counteract upside inflation risks, could inject additional uncertainty into the economic outlook. This uncertainty, coinciding with more onerous bank lending standards that are making it harder for households and businesses to get loans, could increase the vulnerability of the economy to higher borrowing costs, with spillover effects for corporate earnings.
Global equities have generated solid returns this year, buoyed by continued robust data out of the U.S. which have allayed prevalent worries around a significant growth slowdown coming into 2023. Lower inflation with ongoing resilience in the labour market have emboldened markets to lean into a benign “soft landing” as the most probable outcome for the economy over the coming quarters.
This optimistic economic view has been reflected in the stock market through a rebound in valuation multiples and stabilisation in consensus earnings estimates. In fixed income markets, compensation for taking credit risk has diminished – reflected in narrower credit spreads – though higher base interest rates have helped keep all-in yields at attractive levels.
Bar chart showing the current forward earnings yield for the MSCI All-Country World Index and the S&P 500 and the yield to worst for the Bloomberg U.S. Corporate Index, the Bloomberg Global Agg Credit Index, the Bloomberg U.S. Corporate High Yield Index, and the Bloomberg Global Corporate High Yield Index, compared to January 1, 2022, and the average since 2002. On a relative basis, the yield advantage that equities commanded over corporate bonds has sharply diminished over the past year.
*Earnings yield is the inverse of the forward price-to-earnings ratio. Bond yield refers to yield to worst for the Bloomberg U.S. Corporate Index, the Bloomberg Global Agg Credit Index, the Bloomberg U.S. Corporate High Yield Index, and the Bloomberg Global Corporate High Yield Index.
Source – RBC Wealth Management, Bloomberg; data through 8/18/23
On balance, we think a modestly defensive stance in portfolios with a focus on relative value remains sensible on the belief that the U.S. economy is likely in the later stages of the business cycle.
While history shows that the late-cycle period usually still delivers positive returns for stocks, we believe investors should prepare for potential bouts of volatility as perceptions about the outlook can shift rapidly. In this part of the cycle, we think equity portfolios can benefit from emphasising companies with robust quality characteristics – lower debt levels, consistent pricing power, reliable cash flow generation, and sustainable dividends – as they tend to be better equipped to weather tougher economic conditions.
Given the rally in equity markets this year, relative value – proxied by the spread of bond yields over equity earnings yields – have moved in favour of bonds. Along these lines, we continue to see timely opportunities in fixed income markets for deploying capital, with government bonds a useful source of portfolio defensiveness and the potential for mid-to-high single-digit returns in corporate credit. Yields in many bond markets have risen to their highest levels in more than a decade. Historically, starting yields have translated closely into annualised returns over the medium term.
This publication has been issued by Royal Bank of Canada on behalf of certain RBC ® companies that form part of the international network of RBC Wealth Management. You should carefully read any risk warnings or regulatory disclosures in this publication or in any other literature accompanying this publication or transmitted to you by Royal Bank of Canada, its affiliates or subsidiaries.
The information contained in this report has been compiled by Royal Bank of Canada and/or its affiliates from sources believed to be reliable, but no representation or warranty, express or implied is made to its accuracy, completeness or correctness. All opinions and estimates contained in this report are judgments as of the date of this report, are subject to change without notice and are provided in good faith but without legal responsibility. This report is not an offer to sell or a solicitation of an offer to buy any securities. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Every province in Canada, state in the U.S. and most countries throughout the world have their own laws regulating the types of securities and other investment products which may be offered to their residents, as well as the process for doing so. As a result, any securities discussed in this report may not be eligible for sale in some jurisdictions. This report is not, and under no circumstances should be construed as, a solicitation to act as a securities broker or dealer in any jurisdiction by any person or company that is not legally permitted to carry on the business of a securities broker or dealer in that jurisdiction. Nothing in this report constitutes legal, accounting or tax advice or individually tailored investment advice.
This material is prepared for general circulation to clients, including clients who are affiliates of Royal Bank of Canada, and does not have regard to the particular circumstances or needs of any specific person who may read it. The investments or services contained in this report may not be suitable for you and it is recommended that you consult an independent investment advisor if you are in doubt about the suitability of such investments or services. To the full extent permitted by law neither Royal Bank of Canada nor any of its affiliates, nor any other person, accepts any liability whatsoever for any direct or consequential loss arising from any use of this report or the information contained herein. No matter contained in this document may be reproduced or copied by any means without the prior consent of Royal Bank of Canada.
Clients of United Kingdom companies may be entitled to compensation from the UK Financial Services Compensation Scheme if any of these entities cannot meet its obligations. This depends on the type of business and the circumstances of the claim. Most types of investment business are covered for up to a total of £85,000. The Channel Island subsidiaries are not covered by the UK Financial Services Compensation Scheme; the offices of Royal Bank of Canada (Channel Islands) Limited in Guernsey and Jersey are covered by the respective compensation schemes in these jurisdictions for deposit taking business only.