Topic 1: Interest rates are high now, but rate cuts expected
Bonds are an important asset class in the current high interest rate environment. As the economy slows, bonds have the potential for capital appreciation. Even if interest rates fall later than forecast, bonds offer regular income while you wait.
Bond yields in the US have declined from the peak in October 2023 due to lower inflation and expectations of rate cuts ahead.
The 10-year US Treasury yield reached 5% in the middle of October, the highest level since 2007. It has since declined to 3.90% (as of 22 December). Bond yields fell significantly after the last US Federal Reserve (Fed) meeting when Fed Chairman Jerome Powell struck a more balanced tone than markets had anticipated. Interest rates are likely to have peaked and the Fed may lower rates from the middle of this year.
Bonds have done well after Fed pauses
Bonds usually perform well when the rate hike cycle is over and do not need a rate cut to rally. History suggests that when the Fed gets to the peak of its rate hike cycle, bonds tend to do much better than cash in the following period (Figure 8).
Bond refers to Bloomberg US Corporate Investment Grade Index. Cash refers to 3-month US Treasury bill. Bond total returns refers to bond coupon plus the change in bond price.
Source: JPMorgan Asset Management (30 November 2023)
Bond yields can fall further in 2024, as growth and inflation slow
Bond yields are likely to continue falling in 2024. As yields decline, bond prices rise. Weaker growth and slowing inflation contribute to lower interest rate expectations, leading to lower yields. Holding cash for yield will become less appealing when short-term interest rates come down. Owning high-quality bonds becomes even more attractive with potential price gains.
Lock in high yields before growth slows and rates fall
Bonds are also supported by uncertainty in the global landscape. Slowing growth as well as geopolitical risk can cause stocks to fluctuate at any time. High quality bonds, as safe havens, can benefit from slow growth and weak sentiment in stock markets. Lock in yields by adding high quality bonds to your portfolio before growth slows and rates fall.
Topic 2: Factors that signal the end of high rates
While central banks are not expected to raise rates further, the key question is how much longer before rates are cut. This depends on four factors (Figure 9).
Starting with the most important, US core inflation
falling towards the Fed’s 2% target would precede the end of high rates. Inflation is a central bank’s main priority. Once inflation is under control, central banks can consider cutting interest rates if that is needed to support economic growth.
The second signal is a weakening jobs market and this can be seen from rising unemployment. Jobseekers will lower expectations of high wages if there are fewer jobs in the market, leading to wages and therefore inflation, to come down.
The third factor that signals impending rate cuts is significant deterioration of the economy, as fewer jobs would lead to people spending less.
The last factor, the most dire, is banks imposing stricter lending standards and, as a result, lend less in view of rising bad loans and defaults. In this scenario when the economy deteriorates, companies face pressure from both weaker economic activity as well as the inability to borrow, restricting hiring and business expansion.
When these factors occur, central banks would shift focus from controlling inflation to supporting economic growth with rate cuts. This is also when markets are expected to be more volatile.
As the first half of this year may see more volatility, spread your portfolio across different types of investments while interest rates are high. A portfolio diversified across different asset classes, regions and industries produces steady returns over time, with lower volatility than one that is made up entirely of stocks or bonds (Figure 10).
#Diversified refers to 60% MSCI World Index and 40% Bloomberg Global Aggregate Bond Index.
Source: UOB PFS Investment Strategists, Bloomberg (15 December 2023)
Topic 3: Dividend investing as interest rates fall
With interest rates forecast to fall in 2024, stocks that pay dividends become more appealing again as cash and bond yields come down. High-quality dividend stocks also have lower volatility than the broader market and become more important in a slowing economy. Dividend stocks have historically done better than other asset classes like bonds and commodities during periods when inflation declines from a peak. This is because they provide income and typically have lower valuations compared to growth stocks.
Asia is an attractive region for dividend stocks
Dividends play a key role in Asian stock markets. The MSCI Asia ex-Japan High Dividend Yield Index, which tracks the performance of quality Asian stocks that pay high dividends, stands out among broader markets. It currently has a dividend yield of 6.1%, much higher than that of the MSCI World High Dividend Yield Index at 3.8% (Figure 11). This attracts income investors who want high and steady dividends from Asian stocks in anticipation of falling interest rates.
Asia ex-Japan refers to MSCI AC Asia ex-Japan High Dividend Yield Index. Global refers to MSCI World High Dividend Yield Index. US refers to MSCI USA High Dividend Yield Index. Europe refers to MSCI Europe High Dividend Yield Index. Japan refers to MSCI Japan High Dividend Yield Index.
Source: UOB PFS Investment Strategists, Bloomberg (15 December 2023)
Relative to other markets, Asian dividend stocks look the cheapest (Figure 12). This gives dividend investing in Asia an overall advantage.
Asia ex-Japan refers to MSCI AC Asia High Dividend Yield Index. Global refers to MSCI World High Dividend Yield Index. US refers to MSCI USA High Dividend Yield Index. Europe refers to MSCI Europe High Dividend Yield Index. Japan refers to MSCI Japan High Dividend Yield Index.
Source: UOB PFS Investment Strategists, Bloomberg (15 December 2023)
Focus on dividend yielding stocks in Asia ex-Japan for income
We are optimistic about Asia ex-Japan, focusing on dividend stocks. The region’s resilient business activity should enable companies to maintain steady dividend distribution. Dividends become more important in supplementing income when bond yields fall.
