Investment Strategy Insights: A Midyear Check-in on Risks to the Base Case

Contrary to expectations, the US economy lost momentum in the first quarter as government expenditures and export growth slowed significantly. The two-speed economy is converging, with retail sales growth trending lower and manufacturing remaining lackluster. A combination of slower momentum in credit growth, the savings rate sitting below its long-term average, and no expectation of a reacceleration in government spending underlie the view that the economy will continue its gradual slowing. While that pace is still far from recessionary and immigration has provided a lift, the decline in productivity growth suggests below-potential performance.

Look for upward surprises in the Consumer Price Index (CPI) to fade as increases in insurance premiums normalize and shelter inflation catches up with the rental surveys. The rate of deflation in durable goods prices accelerated in the second quarter at the fastest pace in 20 years, showing underlying pricing power is weak outside of services. Against this backdrop, CPI should reach close to 2% in the first quarter of 2025.

While the Fed remains cautious, seeing only one cut in 2024, the market is pricing closer to two cuts this year, with the first likely between September and November. With sufficient evidence of lower inflation to be received only after the July meeting, the likely start date for the cutting cycle is now later than previously thought.

With the European Central Bank (ECB) commencing its cutting cycle and the remaining big central banks (excluding the BOJ) set to ease this year, global growth has generally come in stronger, helped by sideways to more stimulatory fiscal policy. As proof, global PMIs are in expansionary territory for the first time since mid-2022. European growth, with the exception of Germany, has bottomed and is commencing an upward trajectory, albeit mild.

The Federal Reserve is attempting to balance a rapidly slowing economy with stubbornly persistent inflation, and the job is proving more difficult than imagined. The European Central Bank cut once this month and raised its inflation forecasts going forward, leaving market participants wondering if everything is under control. Norges, the Norwegian central bank, left rates unchanged at 4.5% and sees no reason to cut this year, believing the economy is doing fine. We believe the Fed’s view is closer to Norway’s than it is to the ECB’s, and there are many reasons to be hawkish for higher rates. For now, we favor a long duration stance for three main reasons: this is an election year; we believe the Fed will follow through with earlier predictions to not seem political; and two prominent banking CEOs are warning of higher rates and either one cut or none.

Another month of economic data showing signs of weakening provided support for a Treasury rally that, in keeping with a common trend over the past year, led to spreads moving in an inverse direction to Treasuries, causing spread widening across most fixed rate credit assets. The Fed’s dot plots have pulled back their easing forecast from three cuts to a single cut, while the market is pricing in two cuts. We continue to see a weakening yet still favorable corporate credit environment combined with less near-term monetary policy support and fairly tight valuations. Overall, we have maintained our CS at a somewhat defensive level despite expectations that coupon yields will drive returns for the rest of the year.

As we look across the relative value spectrum of credit, nothing stands out as being particularly cheap or expensive. Therefore, we have become more neutral with respect to asset and geographic allocations. There have been some surprise election outcomes resulting in greater political risks in Europe that have the potential to introduce volatility across rates and credit markets this summer.

Factors supporting the US dollar earlier in the year continue to dissipate, while the euro faces its own issues given a weaker growth outlook (albeit stabilizing from a low base) in Germany and France. The ECB’s June cut was well telegraphed, and its path to further monetary easing remains clearer than the Fed’s. We are neutral on the US dollar against the euro and a wide range of currencies.

The last 18 months have seen the euro and US dollar trading in the same range (1.05-1.10), forcing FX volatility lower. Beyond November’s US elections, it’s increasingly difficult to find a catalyst that would push the cross outside this range on a sustainable basis. Waning support for the US dollar is justified by budding evidence that areas of the US economy are slowing, reining in the policy divergence that kept the US dollar in demand in the first quarter. Terms of trade support for the US dollar has also reversed with the recent drop in oil prices. Moderating US inflation and higher breakeven levels in jobs growth should provide the Fed with a greenlight to start adjusting interest rates lower in the second half. Fed Chairman Powell continues to hint that the next Fed move will be a cut, but Fed speakers continue to sound hawkish, and we believe a data-sensitive Fed will remain patient.

The Bank of Japan faces the dilemma of trying to raise interest rates at a measured pace without losing the market’s trust. The recent intervention by Japan’s Ministry of Finance to prop up the Japanese yen was only a temporary fix. With outflows continuing unabated, the Japanese yen is at risk of new losses despite being significantly undervalued on a historical basis.

Positive, but not bullish: That was the consensus outlook of 70 companies we met with at a recent bank conference, corroborating our market expectations for no material deterioration in fundamentals, continued fair valuations, and technicals that are supportive due to net negative issuance for the year. Major emerging market (EM) elections, now mostly in the rearview mirror, produced a few surprises, but market reaction was generally muted. The risk for EM now comes from the US election, with expectations that market volatility will tick up in anticipation.

Now more able than in the past to borrow locally for a longer term, EM corporations have become less reliant on debt issuance in US dollars. In addition, companies are looking to fund capex from their balance sheets rather than add leverage. In commodities, we see a bottoming-out in the petrochemical sector, a positive outlook for gold, and a neutral outlook for copper, with major projects now online and a relatively light pipeline of new projects. We expect oil to stay within an $80-$85 per barrel price range for 2024.

In Turkey, a surprise rate hike along with a restrictive loan policy has meant that banks’ net interest margin has been declining. For 2025, we expect a recovery, the start of rate cuts, and easing of restrictive monetary policy. The key for Turkey is that conventional policy continues. Mexico’s election supermajority was a surprise, but expect policy continuation to be neutral for US/Mexico ties, with some tail risk of AMLO policy changes in September. There is some risk for more tariffs and increased protectionism regardless of who wins in the US, but look for Mexico to continue to be an attractive US trading partner. As the Pacific transitions from El Nino to La Nina, look for much higher agricultural yields and exports next year, with Brazil a beneficiary.

We maintain our global macro scenario weights at 70% for stabilization and 15% each for recession and extension.

While Chair Powell has postponed interest rate cuts, he has moved forward with quantitative tightening, tapering more aggressively than anticipated. Together with the Treasury-launched bond buyback, we will likely see a soft version of yield curve control in the US. With the ECB rate cut in June and expected rate cuts in July by the Bank of England and the People’s Bank of China, a global easing cycle is under way.

After an unexpected rise in the first quarter, we see indications that inflation is starting to decrease again. Rental prices and used car prices are beginning to decline, and the outlook for inflation in goods remains subdued, partly due to China’s efforts to boost exports. A more relaxed job market is highlighting the benefits of increased immigration, with employment and wages moving from overheated to a more balanced state often referred to as “Goldilocks” territory.

Markets are always about cash flows and capitalization rates, the latter driven by central bank policies and prevailing risks. This dynamic, along with the tapering of QT, indicates potentially more favorable capitalization rates over the next nine to 18 months, supporting long-duration risk assets. Now it’s up to earnings to continue moving north after slightly exceeding expectations in the US in the first quarter, and a bit more so in some areas outside of the US. With earnings and capitalization rates moving in a favorable direction, we keep our score at a modestly constructive 2.5.

Equity markets have hit all-time highs as inflation expectations moderate slightly. The rise continues to be top-heavy as market breadth remains weak.

Rolling de-stocking continues across the industrial economy, though companies are becoming more confident that the worst is behind them. Second-half sales should see a boost from the end of de-stocking. It’s a similar story in portions of healthcare, where de-stocking appears to have bottomed out and funding activity is rebounding. Consumer excess savings appear to have normalized, but we have yet to see any significant weakening of spending from current levels. The AI sector remains a standout, exhibiting the strongest trends, with the outlook further upgraded by increased capex guides from major hyperscale companies. IT spending has not rebounded, but this should be a temporary phase associated with the Covid-related pull-forward of demand as well as the evaluation and development stages of AI implementation.

In China, export-related consumer segments show strong growth. Electric vehicle (EV) penetration of the auto market surpassed 50% in May. However, industrial automation orders are slowing, mainly due to declining capex in solar and NEVs (new EVs), and in healthcare there is continued pressure on drug prices. In India, consumer staples and discretionary companies with exposure to rural areas have improved guidance. The IT sector, however, remains less upbeat and counts on the second half for improvement. Taiwan and Korea continue to benefit from AI momentum, with some investors questioning if it has run too far too soon.

In Latin America and EMEA, political risk – something we prefer to avoid – took center stage. The landslide victory for Claudia Sheinbaum and the Morena Party in Mexico brought new constitutional reforms back on the table, which caused a large sell-off in equities. In EMEA, South African equities responded positively to the formation of the coalition government. In emerging Europe, markets have been volatile due to the French elections.

The market’s breadth has improved moderately. Although investors have low conviction in bottom-up fundamentals, this is nonetheless a small improvement over the heavily top-down and sentiment-driven behavior seen in previous months. In our investment decisions, we try to look as much as possible past such factors and focus on companies with strong and improving business models, quality management, sound financial structure, and proper adherence to ESG values.

Our US Conviction Score is virtually unchanged as credit spread tightening of five basis points and curve flattening of three basis points almost offset each other. Our global credit forecasts are negative, and our relative model favors EM over developed markets (DM). In DM, the model favors banking, finance companies, and industrials; it dislikes utilities and communications. Among EM industries, it likes infrastructure, pulp and paper, and metals and mining. It dislikes real estate, transportation, and diversified companies. Our global rates model forecasts lower yields and a steeper curve globally. The rates view expressed in our G10 model portfolio is overweight global duration; overweight North America; and, in Europe, overweight Belgium, Spain, and Austria while underweight France and Germany. It is also overweight Japan and underweight Oceania. Along the curve, it is overweight in the two-year and 20-year and underweight in five-, 10-, and 30-year durations.

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