Rising US Yields Bolstering Asset Class Strategy

The global economy picked up momentum in July, providing initial confirmation to our view that growth had troughed and would improve in the second half of 2013. Most notably, manufacturing purchasing managers' indices, from China to the US, were in expansionary territory (above 50.0) in July, with the US hitting a particularly impressive 55.4. Even the eurozone published a reading above 50.0 for the first time in two years.

Against this backdrop it is little surprise that bond markets are selling off, with the US 10-Year Treasury yield above 2.7% and looking like it could potentially explode higher. Though we do not believe it provides the most appropriate fundamental comparison, the side-by-side chart of 10-year UST yields in the 1994 and 2013 bond sell-offs shows eerie similarities, and suggests further fixed income downside. As US equity markets hit new highs, we still see little value in fixed income, and think 10-year Treasuries could end the year at 2.75-3.00%.

This will have implications across global markets , as rising safe-haven yields will increase the opportunity cost of investing in a variety of asset classes. Consumer discretionary stocks, for example, look like they may break higher against staples stocks. As the chart below shows, the discretionary to staples ratio (based on the MSCI World indices) tracks the UST yield fairly closely . This is sensible, given that higher yields indicate a reflationary, risk-on environment, in which discretionary shares should outperform. A break higher would also provide confirmation that growth, in developed markets at least (this chart represents the MSCI World), is on an increasingly sustainable footing.

Growth Rebound Underway
Manufacturing Purchasing Managers' Indices

Rising US Yields Bolstering Asset Class Strategy

The global economy picked up momentum in July, providing initial confirmation to our view that growth had troughed and would improve in the second half of 2013. Most notably, manufacturing purchasing managers' indices, from China to the US, were in expansionary territory (above 50.0) in July, with the US hitting a particularly impressive 55.4. Even the eurozone published a reading above 50.0 for the first time in two years.

Growth Rebound Underway
Manufacturing Purchasing Managers' Indices

Against this backdrop it is little surprise that bond markets are selling off, with the US 10-Year Treasury yield above 2.7% and looking like it could potentially explode higher. Though we do not believe it provides the most appropriate fundamental comparison, the side-by-side chart of 10-year UST yields in the 1994 and 2013 bond sell-offs shows eerie similarities, and suggests further fixed income downside. As US equity markets hit new highs, we still see little value in fixed income, and think 10-year Treasuries could end the year at 2.75-3.00%.

Moving Ominously Higher
US 10 Year Treasury - 1994 versus 2013 Compared

This will have implications across global markets , as rising safe-haven yields will increase the opportunity cost of investing in a variety of asset classes. Consumer discretionary stocks, for example, look like they may break higher against staples stocks. As the chart below shows, the discretionary to staples ratio (based on the MSCI World indices) tracks the UST yield fairly closely . This is sensible, given that higher yields indicate a reflationary, risk-on environment, in which discretionary shares should outperform. A break higher would also provide confirmation that growth, in developed markets at least (this chart represents the MSCI World), is on an increasingly sustainable footing.

Risk Is Coming Back
MSCI World Discretionary Over Staples Stocks And US 10 Year Treasury Yield (%)

Emerging markets that have benefited from foreign inflows to finance massive current account deficits are also facing increasing pressure in the face of higher US yields . The weakness in current account deficit currencies (INR, ZAR, TRY) has tracked UST yields closely. Though we see stability in these currencies after a major sell-off, a further spike in US yields would put these and other EM currencies under further pressure.

Opportunity Costs
EM FX Versus US$ (Rebased To May 1 2013) And US 10-Year Treasury Yield (%)

In general, we continue to prefer developed to emerging market stocks. The ratio of the MSCI World to the MSCI Emerging Markets index has hit a four-and-a-half-year high, and looks set for further gains as the S&P 500 enters record territory.

Reaching New Highs
Ratio of MSCI World To MSCI Emerging Markets

We think that there is increasingly good value in European equities over a multi-year horizon, compared with their US counterparts. We have been waiting for several quarters for a signal to pull the trigger on a relative Euro-over-US equities view, but so far, the signals continue to point to US outperformance. We have watched the differential of US over eurozone PMIs as a proxy for economic activity and risk appetite, particularly as it has tracked the US's equity outperformance quite well in the past few years. With the US's strong PMI reading relative to euroland's in July, the trend remains intact.

US Still Outperforming Euroland
US - Eurozone PMI Differential And US Equity Outperformance

One of our key global views is that the broader equity market would outperform commodities, which has certainly been the case since March 2012 when our Commodities team laid out the case. One chart that en capsulates the macro and market impact of this view is the Australian dollar plotted against the ratio of the MSCI World versus the MSCI Metals and Mining index. The AUD is one of our least favoured currencies, as it is highly leveraged to China and the commodities cycle , both of which are headed in the wrong direction . Falling commodities prices, combined with rising US yields and falling Australian yields, are a recipe for a significantly weaker AUD. We maintain our US$0.75/AUD long-term target (compared with the current level of US$0.89/AUD - the chart shows the inverted ratio, AUD/US$ ).

AUD And Commodities Under Pressure
Ratio Of MSCI World To MSCI Metals And Mining Index And AUD/US$
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