Photo: Ingvild Borgen © DNB

By Ingvild Borgen, Portfolio Manager at DNB Asset Management

The rise in US government bond yields resumed with renewed force in September, weighing on most areas of fixed income and leaving the bond market with weak returns overall. Equity markets also delivered only modest gains, yet investors seem largely unfazed by higher rates, mainly because the increase is being driven by resilient economic growth.

That said, the sharpest moves in September came in the rates market. Yields on US Treasuries, at both short and long maturities, rose markedly in the second half of the month. In our view, strong growth and demand in the US economy have been the main driver of higher rates since the start of the year, which helps explain why equity markets have, on the whole, taken the move in their stride.

We are, however, seeing signs that equities react more negatively when rates move abruptly, with large shifts over a short period. In the final week of September, the benchmark 10-year Treasury yield moved sharply on several days, apparently unsettling equities and other risk assets. Shares fell moderately on those days, while US high-yield credit spreads widened over the same week.

The simultaneous rise in oil prices and interest rates is also weighing on risk assets. On the one hand, more expensive oil is a drag on the real economy in its own right. On the other, it creates uncertainty about what is driving rates higher. A rise in rates caused by higher oil prices is worse for equities than one caused by robust demand. As noted above, we believe the latter is still the dominant factor. However, concerns about the situation in Iran and its impact on commodity prices are also pushing up rate expectations and, in turn, long-term market rates.

In our view, the impact of any further rise in rates on equities therefore depends on two conditions. First, the move must continue to be driven mainly by improving growth prospects rather than by fears over oil prices. Second, rate volatility must remain relatively contained, without repeated one-day jumps of 10 to 15 basis points like those seen several times in the last week of September.

We believe both conditions can be met, and we are therefore not particularly concerned about equities, even if market rates were to edge slightly higher from here. A robust US economy that is relatively insensitive to higher rates, combined with equities underpinned by strong earnings growth, should be able to absorb rates in the 5% to 6% range.

Our main concern remains the equity rally’s heavy reliance on extremely ambitious earnings forecasts, largely tied to a single theme: artificial intelligence. By our rough estimate, technology companies account for two-thirds of the upgrade in earnings expectations since the start of the year. Industrials and materials companies have also contributed significantly, and much of that contribution is again likely to be linked to profits from the build-out of AI infrastructure, including data centres. The vast sums being invested in this infrastructure are therefore playing a decisive role in sustaining the equity rally. However, there is still considerable uncertainty about how profitable these investments will ultimately prove, and how long the current pace can be sustained.

Overall, we are currently comfortable with a neutral allocation between equities and bonds across our funds and portfolios. This positioning reflects both the many uncertainties facing equity markets, from interest rates and energy prices to AI-related earnings, and the improvement in running yields on bonds as market rates rise.

Our market view for October is unchanged

Over the past month, we have made no portfolio changes that would signal a shift in our overall market view. We remain overweight technology, despite our scepticism about lofty earnings forecasts, and are even considering increasing our exposure. Two factors explain why we remain positive on technology stocks.

First, we are not alone in questioning AI-driven earnings growth. Earnings forecasts for information technology companies are still being revised up sharply, yet their share prices have failed to keep pace in recent months. This explains why valuations, measured as share prices relative to expected earnings, have fallen this year across the market, and particularly in technology. Investors clearly doubt that these forecasts will be met or that such strong growth can be sustained. Even though memory-chip and semiconductor makers continue to gain ground, these stocks no longer generate the enthusiasm they did in the first half of the year.

Second, as long as investment remains strong and shows no sign of slowing, many technology companies will continue to benefit. This trend could last another one to two years, in which case these companies should continue to outperform the broader market.

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