Investment Strategy Insights: The US Fiscal Thrust Is the Stealth Driver of Economic Growth

Stance: Whether positive or negative, the direction of regional conviction scores remains consistent, if somewhat moderated. In China, weaker-than-anticipated manufacturing data, combined with ongoing challenges in the property market, have lessened the expected positive impact of the reopening. In the US, the still relatively strong labor market and substantial fiscal spending have provided a more positive outlook for growth, although very low growth or a mild recession remain possibilities. In July, equity markets rallied on lower-than-expected inflation figures in the US, followed by a similar print in the UK. While the lower core consumer price index is good news for the Federal Reserve and the US economy, the overall inflation picture remains unclear. The month-on-month inflation print of 0.2% marks the first time in the past year that core inflation has aligned with the Fed’s inflation target. The recent miss in inflation was primarily driven by lower-than-expected prices of goods, particularly consumer goods, while most service sectors continued to experience positive monthly inflation. This could be an early warning sign of a weaker consumer or it might indicate that retailers are trying to sell off excess inventory accumulated due to supply chain concerns. The combination of stubbornly high services inflation and elevated earnings metrics suggests the possibility that overall inflation will persist. The market has begun to recognize the impact of fiscal spending on the US economy, as the deficit has rapidly risen to 8.5% of GDP, up almost five percentage points from the second quarter of 2022. This unexpected development likely explains part of the strength in the labor market, as government-related employment continues to grow at a rate of 3.5% year-on-year (y/y), surpassing both cyclical (2.4% y/y) and non-cyclical (0.5% y/y) private employment growth. In contrast, despite weaker growth and PMIs throughout the region, the European Central Bank continues to hike interest rates as it focuses on inflation. Risks: Inflation falling faster than expected or the Fed looking through services inflation and pivoting earlier; systemic issues in either Europe or the US; more resilient economic fundamentals across Europe and the US.

The overnight reverse repo facility no longer offers the highest yield on the US Treasury curve. T-Bills now yield more than SOFR and are very attractive despite tremendous issuance. Here’s a summer thought experiment based on the fact that the money the US Treasury spends essentially becomes some else’s deposit. Since 2006, US Treasury debt has grown from $5 trillion to $25 trillion, meaning that $20 trillion was spent in the last 17 years. In normal times, that $20 trillion in extra spending would be financed by issuing debt, which would be paid for with $20 trillion from private hands, ensuring that excess money didn’t drive inflation. This time, while $20 trillion was spent, only $11 trillion came from the private market. The remainder was created by the Federal Reserve. That means an extra $9 trillion is churning around the system and contributing to inflation. This “extra” money has contributed to problems including negative rates, meme stocks, and ballooning prices for homes and virtually all assets.

In the US, the economy and corporate earnings have surprised to the upside, while in other regions, notably China, the opposite has occurred. Globally, while the overall outlook has improved, the expected negative effects of rate hikes are expected to have more of an impact over the next 12 months as some of the fiscal stimulus expires. Overall recession risks are lower and, more importantly, any recession is expected to be much milder than anticipated at the start of the year. Unfortunately, the less negative credit outlook is now fully reflected in credit spreads, with high yield (HY) trading into the 370s and investment grade (IG) in the 110s. Since spreads are at or through our near-term range, we are downgrading our score. Lower supply in leveraged finance has contributed to the recent market strength, but we expect refinancing issuance to increase with a stronger market and higher risk appetites. The BB-BBB differential has tightened below +100 levels, and CCCs also have rallied strongly. While there is still value in the single-B segment, we believe it is prudent to shift more into IG versus HY, with expectations of some decompression in the months ahead. Emerging market (EM) credit generally and China in particular has not rallied as much as US credit, but short-term investor sentiment appears to be negative. For technical reasons, we would not yet add exposure.

Monetary policy acting with a lag appears to be gaining traction after the June US CPI release. Labor market data and fiscal spending from earlier in the year remain tailwinds for the Fed’s narrative of keeping FOMC meetings “live,” but financial markets have started to price in a Fed peak. Ignoring the US economy’s jobs-related resilience in the second quarter, the market has shown waning support for the US dollar, suggesting rate differentials play a bigger role in the currency’s outlook than growth differentials. The euro/US dollar relationship has been incredibly sensitive to shifts in the front-yield curve as a proxy for monetary policy. Since US exceptionalism is expected to fade over the next 12 months, and the Fed may cut interest rates sooner than the ECB, we tend to favor a weaker US dollar trend, which we expect to persist into the fourth quarter. However, we have already met our 12-month target of 1.1250 in the euro/US dollar, causing us to turn neutral in the near term. The next trigger for a shift in US dollar direction could come from policy action or lack thereof in China. An uneven growth recovery in China and lack of policy response hurt sentiment in China in the second quarter, yet broader EM growth is still relishing China’s reopening and can benefit from a clearer path toward monetary policy easing, supporting a wider EM/DM growth differential. Since rapid disinflation in many EM countries and positive real policy yields support EM currencies, we expect EM foreign exchange to remain stable in the first part of the rate-cutting cycle as front-end yields will continue to attract offsetting inflows.

While China’s economy is expected to pick up in the third quarter on a quarter-over-quarter basis, our annual growth forecast of 5.1% — which was below consensus until some drastic revisions by banks in July — is based on additional policy stimulus, which we expect will be targeted and selective rather than broad-based. Weakness in the property sector, including declining land sales, and moderate investment in infrastructure weigh on the economic outlook, hurting overall confidence. China’s second-quarter growth has been underwhelming, yet there is no urgency from policymakers to revive the economy. Our growth projections provide support for our thesis of a wider EM/DM growth differential, albeit to a lesser extent than earlier in the year. The size of the onshore local government financing vehicle (LGFV) market beckons a watchful eye, but stress tests suggest systemic risk is low and defaults have been prevented so far. The offshore LGFV market is very modest in comparison, and international investors are less concerned. Our global macro scenario weights remain unchanged at 55% “classical,” 25% “pivot,” 10% “stagflation,” and 10% “soft landing.” We have revised lower the US Treasury yield forecast in the soft-landing scenario as a Fed pause and general rates momentum argue for a lower outcome even in a flat growth environment. Favorable disinflation trends in EM, a weakening US dollar trend, and growing evidence of a widening EM/DM growth differential support our constructive view on emerging markets. EM corporate IG continues to offer the most attractive risk-adjusted returns, yet in a world of Fed pausing and subsiding rates volatility, extending duration and adding sovereign IG has become attractive.

Consumer spending and labor markets are holding up well. Companies continue to feel good about the near term. Supply chains are better. Evercore ISI company survey results have continued to moderate, but caution appears to be easing, not intensifying. We are still finding opportunities to upgrade the portfolio and invest in advantaged companies at valuations below typically high levels. Related themes and exposures where we are finding opportunities for our global focus include generative AI opportunities, particularly around semiconductors and hardware, and life sciences and healthcare equipment and services, on post-pandemic demand normalization. We remain overweight industrials but have reduced our exposure, as the group continues to trade at peak multiples on earnings estimates – which are increasingly at risk of downward revisions as orders decelerate and companies work off the strong backlogs built in recent years.

We cautiously improved our score, prompted by recent attempts on the part of the US and China to lessen tensions and Beijing’s less restrictive stance toward private businesses. The Chinese government has strong incentives to support the private sector as the weakening macro environment is causing the outlook to be downgraded in several sectors. India’s economy is performing better, with industrial production and infrastructure metrics on an uptrend and favorable demographics continuing to be highly supportive. The market’s demanding multiples, however, underscore many companies’ excellent growth prospects. In Latin America, the shift into less defensive names in Brazil continues, although at a slower pace than in previous weeks. In Central and Eastern Europe, companies have largely adapted to the impact of the war in Ukraine and are seeing earnings recover in select sectors. Results so far point to strong beats from consumer goods, financials, and industrials in Latin America, and from banks in India; mixed results are seen in telecoms and semiconductors, with good reporting but light guidance.

Driven by a flatter curve (-30 bps) that dominates the tighter BBB credit spread (-14 bps), our score has deteriorated slightly. With global credit forecasts more negative, our model slightly favors EM over DM. In DM industries, our model favors industrials, technology, finance companies, transportation, and capital goods, and dislikes communications, basic industry, energy, banking, REITs, and utilities. In EM, the model likes transportation, industrials, and oil and gas and dislikes real estate and metals. Our global rates model forecasts lower yields globally, and a flatter curve in Europe, the UK, Oceania, and Japan, but a steeper curve in the US and Canada. The rates view expressed in our G10 model portfolio is overweight global duration. It is overweight North America, the UK, and Japan, and underweight Europe. Along the curve, we still position for flattening with overweights in two-year and 20-year Treasuries versus underweights in the five-year, 10-year, and 30-year securities.