Investment Strategy Insights: A Rare Window of Growth Convergence Between the US and the Rest

Contrary to expectations, the US economy lost momentum in the first quarter. Government expenditures and export growth slowed significantly, while retail sales growth trended lower and manufacturing remained in contractionary territory. Slower momentum in credit growth coupled with the savings rate sitting below its long-term average — amid no expectations of a reacceleration of growth in government spending — underlie the view that the economy will continue its gradual slowing. While the economy’s pace is still far from recessionary and immigration has provided a lift, the fall in productivity growth suggests a below-potential pace.

Upward surprises in inflation are expected to fade as increases in insurance premiums normalize and home prices start aligning with rental surveys. Durable goods prices are deflating at the fastest pace in 20 years, showing that underlying pricing power is weak outside of services. Against this backdrop, the Consumer Price Index should reach close to 2% in the first quarter of 2025.

Due to the slower growth, equities markets are again pricing in two cuts for the year (up from one cut last month), with the likely start date sometime between September and November, which is now later than previously anticipated since sufficient evidence of lower inflation would be available only after the Federal Reserve’s July meeting. With all big central banks save for the Bank of Japan set to ease this year, and helped by sideways to more stimulatory fiscal policy, global growth has generally come in stronger than expected. In fact, the global purchasing managers’ index (PMI) is in expansionary territory for the first time since mid-2022. European growth, except for Germany, also has bottomed and has commenced an upward trajectory, however mild.

While the Federal Reserve attempts to balance a rapidly slowing economy with stubbornly persistent inflation, market participants are recognizing that inflation may continue to be problematic. This new backdrop of higher rates for longer will ultimately change the calculus for risk assets. We recognize the problem and believe that government spending without commensurate tax hikes will be detrimental for risk assets in the future. But that future is not now. This is an election year, and the current administration is doing everything in its power to lower prices and relieve the financial stresses that consumers face.

After a surprising rise at the start the year, the most recent inflation data was closer to expectations as economic data and sentiment turned bearish. The net impact was a rally in base rates and some marginal compression in already tight spreads. Yields declined for fixed rate credit, largely driven by rates, as the five-year part of the curve rallied by nearly 30 basis points (bps). Investment grade (IG) spreads are approaching +80 levels once again while high yield (HY) spreads have dipped below +300. The BB-BBB differential is below +70, representing a highly bullish credit market outlook. While floating-rate credit superficially looks much cheaper, with a majority of issues offered above par, negative convexity and repricing activity is in full swing. While strong technical demand and starting point fundamentals should keep spreads from widening meaningfully anytime soon, the tight valuations have led us to downgrade our CS to an incrementally more cautious bias.

An environment of higher US rates for longer, which markets now anticipate, typically means lower risk appetites and investors demanding US dollars as a safe haven. Fed Chair Powell has taken the sting out of that outlook by saying the Fed is unlikely to raise interest rates one more time in this cycle, refocusing the market on the potential for one or two cuts in 2024 and further cuts next year as the Fed’s expectations of inflation falling toward its 2% target are met. In addition, the slow improvement seen in recent US economic data suggests that the factors driving the US dollar higher in the first quarter could be fading. Perceived policy divergence, terms of trade, and ongoing US exceptionalism have been strong factors in support of a stronger US dollar versus the euro, yet the euro/US dollar ratio, which has stayed shy of testing the 1.05 level, would be considered appropriate in a “higher for longer” scenario. Long-term valuations and market positioning also have weighed on the US dollar, affirming our decision to move our conviction score to neutral last month. Should the euro/US dollar ratio be cemented in its 1.05-1.10 range, foreign exchange (FX) volatility could dampen further. We believe the European Central Bank (ECB) now has a clearer path to cut interest rates three or four times over the next 12 months, starting in June. Inflation is moderating, and while parts of the eurozone see signs of recovery, Germany and France are lagging.

Recent and pending elections may affect markets in India, Mexico, and South Africa. In India, our base case is that Prime Minister Narendra Modi and his party win a third term, implying policy continuity and growth expectations of 6.5% over the medium term. In Mexico, the election of Claudia Sheinbaum as president gives a slightly more negative feel, with AMLO potentially still having policy influence as he stays on as leader of Morena party. In South Africa, the African National Congress (ANC) received just 40% of the vote and will enter into a coalition government. We place a higher risk than the market on a more extreme coalition being formed.

Regarding US dollar strength, we see the FX channel as the main transmission mechanism of US rate moves to emerging market (EM) sovereigns, requiring EM central banks to be cognizant of dollar strength in their policy decisions. Decoupling requires a weak or stable dollar environment to avoid FX depreciation; otherwise it would create domestic inflationary pressures for EMs, thus undermining any rate cuts. FX pass-through to inflation will vary across countries but remains a key component in central bank reactions. Latin American currencies and rates are most sensitive to significant US rate moves. In Asia, the rising cost of funding and FX risks are negatives for credit fundamentals, but a majority of issuers in our coverage universe will be resilient in withstanding the potential headwinds. In corporates, the story is more mixed in terms of the impact from USD strength. We have maintained our global macro scenario weightings.

US inflation was surprisingly strong in the first quarter, pushing up interest rates and stalling the equity rally. Importantly, the reacceleration of inflation appears to be only partly due to demand strength. Supply strength, on the other hand, appears more durable. All told, the uptick in inflation appears to have little to do with domestically generated inflationary pressures, and the contributing factors don’t appear to have much staying power. Eras of supply-led growth are disinflationary by nature and good for growth – both of which create a healthy backdrop for financial assets.

Interest rates have been pressured higher by a strong investment appetite as savings dwindle despite higher rates. A widening fiscal deficit has also added to these pressures. Aggressive spending in 2023-2024 as a result of several 10-year appropriations, including the IRA and CHIPS Acts, is largely responsible for the deficit widening as the economy gained steam. Any easing in the pace of Treasury issuance to fund the expanding deficit would be an upside surprise.

Liquidity is fungible and is about to become more generous. While the Fed’s policy rate cuts will likely be delayed until year-end, the Fed is moving ahead in tapering the pace of QT, which is one form of easing. Outside the US, the Bank of Japan — while finally ending yield curve control and raising short-term rates — continues its quantitative easing by holding liquidity instead of tightening, which had been expected. The People’s Bank of China at long last is beginning a modest dose of QE, and the European Central Bank has become quite clear that it will not wait for the Fed and will begin easing in June. With growth proving resilient, earnings inflecting higher, and liquidity about to become more generous, we became more constructive mid-May and began adding risk to reflect a CS of 2.5.

Equity markets have experienced volatility due to the uncertainties around Fed monetary policy as economic datapoints have become mixed. Although the latest Fed meeting suggests a higher-for-longer scenario due to persistent inflation, the possibility of further rate hikes has been dismissed, which has provided some relief to markets. Earnings in the first quarter have been mixed but are trending in a positive direction outside of the software and services sector, which is seeing persistent weakness in IT spending. Industrials and autos remain challenged, but many of these companies are becoming more constructive and are calling for a better second half. In other sectors, first-quarter earnings point toward continuing improvement in end demand, though the recovery appears shallower than expected. AI-exposed hardware remains a standout, exhibiting the strongest trends, with the outlook further upgraded by increased capex guidance from major hyperscale companies. Consumer companies continue to progress steadily, though caution is warranted due to weakening payroll and consumer confidence indicators.

EM equities are up 14.6% since the lows of January amid only minor positive earnings revisions. The index is now at a small premium to its forward price/earnings (P/E) ratios. To generate more upside, investors would need to see further earnings gains or risk-on drivers such as US rate cuts.

In China, the index’s 23% rally off the year’s lows puts it broadly in line with its own historical forward P/E. Investors are rapidly closing the underweight, but the next leg of outperformance will require earnings-per-share (EPS) upgrades. The government recently announced more details in support of the auto and property industries. Domestic consumption demand remains tepid, but high-frequency data suggest overall stabilization. In India, equity markets have been betting on a return of the ruling party after the elections and for the momentum of infrastructure spending and structural reforms to pick up.

In Latin America, first-quarter earnings in Brazil have been mixed but show improvement over fourth-quarter results. Of note is the strength in healthcare, metals, and consumer but weakness in telecoms and utilities. In Mexico, results have been good, with more beats than misses. In EMEA, reports are just starting to flow in. Results thus far have been stronger than forecast in financials but lagging in food retailers due to competition.

Investors exhibit low conviction in bottom-up fundamentals, which is nonetheless an improvement compared with the heavily top-down and sentiment-driven behavior seen in previous months. Geopolitical and macro factors continue to play a large role, but one that is gradually diminishing. 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 improved, driven by credit spread tightening of 3 bps and curve steepening of 4 bps. Global credit forecasts are negative, and our relative model favors EM over DM. In DM, industries the model favors are banking, capital goods, and finance companies; it dislikes utilities and communications. Among EM industries, the model likes infrastructure, oil and gas, 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, North America, Belgium, Italy, Spain, and Japan. It is underweight France, Germany, and Oceania. Along the curve, it is overweight in the two-year and 20-year and underweight in the five-, 10-, and 30-year.

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