Wall Street Research Pro Like Japan, Defensive Stocks, Bonds

Chang spoke with Barron’s on June 6 about looming economic problems, the parallels between developed and emerging markets, and why the aging of the baby boomers demands a rethink of interest-rate assumptions. An edited version of the discussion follows.

Barron’s: Do you see a disconnect between the stock market and the economy?

Joyce Chang: There are expectations for a soft landing without too much pain to profits, labor markets, or credit availability—and a consensus view that inflation is coming down and central banks are largely done with tightening. But the recession risks haven’t gone away; they might just take longer to materialize. There’s a bigger risk that this expansion goes on longer than expected and we end up with higher terminal policy rates.

A recent J.P. Morgan survey showed investors holding a fair amount of cash. What does your outlook mean for portfolios?

Cash has underperformed fixed income and equities. People are getting forced back into the market—even if they don’t have the conviction. The top three performing asset classes this year are Japanese equities, European equities, and then U.S. equities.

Which is vulnerable to a selloff?

Japan is probably less vulnerable. We expect Japan to exit from its yield-curve control policy [capping 10-year bond yields] in the coming months, but the Bank of Japan’s exit from negative interest rates could take much longer. We expect them to widen the 10-year trading band [for rates] while guiding against interest-rate hikes and still maintaining dovish guidance on rate normalization. With the Bank of Japan holding about half of the outstanding Japanese government bonds, we expect them to prioritize market functionality.

What does this mean for Japanese stocks?

Japan is now in a transitional period toward a new inflationary era. Companies with pricing power are promising, as they can pass on prices and raise wages at a different pace than before.

We prefer Japanese equities to the U.S. and Europe, as the transition to an inflation economy has just begun and Japanese corporations have 25% excess cash on their balance sheets. Plus, Japan’s economic recovery still has momentum, since Covid restrictions and supply disruptions persisted for longer than in many other countries.

Our analysts are more bearish on the

S&P 500 index

and the euro zone. Europe is at the peak of a growth cycle, with energy prices weaker than expected last year, but the growth momentum may be waning.

What is the concern with the U.S.?

In the U.S., some of the excess savings will come down. And while the stress in regional banks might not be systemic, there is more fallout to come. Also, the stock market has performed strongly on very narrow leadership—five companies have driven most of the rally this year. That is one reason why we are more cautious about the outlook for U.S. stocks and recommend long-duration government bonds.

Which stock sectors look best?

We recommend that investors broaden their allocation to stocks that rank 11 to 50 by size in the S&P 500, where valuation is [much] cheaper than for the 10 largest stocks. In terms of sectors, we see further room for a rotation into defensive stocks, including healthcare, utilities, and staples. We see a shift away from value and growth sectors like industrials, consumer discretionary, technology, and financials, and rate-sensitive areas such as real estate and small-caps.

The U.S. and Europe have seen bank failures this year. What else could break?

Our analysts estimate that the U.S. and European office market is around $950 billion, so it isn’t systemic. But there has been a jump in delinquency rates, and they could move higher.

Vacancy rates for office space are running at 13%—similar to the [2008-09] global financial crisis. Some commercial mortgage-backed loans have already gone into special servicing in hopes of receiving some modification relief. There is more stress in some segments of commercial real estate.

You study demographics. What is the impact of the shrinking working-age population in China and aging populations in the U.S. and Europe?

There is a debate around this. We think it means higher yields. Life expectancy and aging have a strong impact on the balance between national savings and investments. Rising life expectancy over the past four decades was a driver in the rising national savings rate and the decline in real bond yields.

Life expectancy plateaued in 2010. Now, we will have a higher share of dis-savings from the elderly and a fall in the savings rate, compared with the rise of the past 40 years. The past arguments about rates aren’t ones I would project, given the demographics.

Where will yields settle?

There isn’t much consensus. The real yield on the 10-year Treasury could fluctuate around 2.5% in the 2030s. The Blue Chip consensus of U.S. economists projects a real yield of only 1% 10 years from now. The Congressional Budget Office estimates 1.8%. The International Monetary Fund sees it back to prepandemic levels of 0.5%.

There is also a lack of consensus around the evolution of the U.S.-China relationship. How do you see things playing out?

There is a huge difference between doing business with China versus being a portfolio investor in China. For those doing business in China, you can’t decouple. You can talk about de-risking and diversifying, but the global economy is integrated. Within that, you need to break down the strategy.

If you are in China for the domestic market, you may be increasing your investment because of the reopening after Covid. If you’re in China to access the Asian market, you might not be changing your strategy. But if you’re in China for the U.S. market, that’s where we are seeing much more of a change in thinking about supply chains and near-shoring.

Where does this leave investors?

There is much more of a debate about whether investors are comfortable in China. The biggest risk now isn’t U.S.-China relations, but domestic confidence [in China’s policy and the economy]. Private enterprises haven’t yet been willing to kick-start spending meaningfully in China, with investment flatlining in 2021 and 2022, even as investments by state-owned enterprises grew by double digits.

More broadly, the issue is whether China can move from an investment-led to a consumption-led economic model as it moves from a labor surplus to a labor deficit and lower growth. We expect China’s economy to grow by 5.9% this year and 5% next year, but if you look at our forecasts into the 2030s, it’s down to 2.5%- 3%—far from the double-digit growth of the aughts.

You see some parallels between what is happening in the U.S. and Europe and emerging markets. Explain.

A lot of the policy challenges [in developed markets] look much more like emerging market challenges: higher debt, higher deficits, central banks that have been lagging, persistent inflation. Policy makers [in developed markets] will have to use multiple tools [for financial stability]. Look at the rise of industrial policy, the rise of fiscal debt, and the role that central banks now play in financial stability. It isn’t just emerging market countries that need this level of government involvement.

What are the risks that investors should be monitoring?

We see four clusters of risk. We are in for shorter, more volatile macroeconomic cycles with lower growth and higher inflation, a falling savings rate, and rising government budget deficits. That’s the macro risk broadly.

The second risk is politics—domestic populism, polarization, inequality, and, on the international side, rising U.S.-China tensions and a broadening out of alliances. There is globalization 3.0 [companies rethinking supply chains] and a de-dollarization move with China’s multipronged effort to internationalize the renminbi.

Do you expect the dollar’s prominence to wane?

We will see more cross-border use of the yuan, especially in countries that don’t have many choices, such as Russia. There is also a question of whether Saudi Arabia or other Middle East countries will use the yuan for settlements.

Chinese yuan cross-border liabilities have risen by about 75% over the past five years. But it’s about China’s cross-border liabilities rather than a global phenomenon, and that is where markets get confused [about the dollar’s future].

What are the other risks?

Climate, which increases the number of extreme weather events—droughts, floods, storms, firestorms—means higher food inflation over the longer term. Biodiversity is worsening dramatically, the world is seeing recurring pandemics, and a higher-inflation environment flows from that.

Fourth is the technology transformation, with digitization and artificial intelligence accelerating. Maybe you get increases in productivity, but does that come with a rise in unemployment? Does it mean worsening cyberfears? The one risk that is always underpriced is cybersecurity.

Tell us some good news.

We expect 2.5% real yields—which is where we were 20 years ago—and a 6.6% average return for 60/40 [stock/bond] portfolios over the next decade. That isn’t terrible.

The other thing that is meaningful to me is more of a focus on not increasing the debt burden. And even on U.S.-China tensions, there have been efforts on both sides to say we need to communicate and veer away from extremist rhetoric around decoupling.

Thanks, Joyce.