The US economy is still headed for a soft landing, even if views on the speed and timing of the touchdown shift after each economic release. The latest US data shows inflation slowing more quickly. The eurozone, by contrast, is seeing persistently higher inflation (see Exhibit 1).
Exhibit 1
Core inflation lower in the US, but still high in the eurozone
The slowing US economy should continue to weigh on job creation and wages, helping inflation to trend lower and Federal Reserve policy rates to fall in the quarters ahead.
This view has largely been priced into bond markets, suggesting that US Treasury returns in the third quarter will be driven primarily by the income from bond yields.
Risks, meanwhile, are growing – particularly for the US government’s fiscal outlook – as we approach the November presidential election. Budget deficit worries could lift inflation expectations.
Slowing consumption should weigh on US economy
While US growth is slowing, we do not expect a recession (the consumer and corporate sectors are too robust for that), but we believe consumption is running out of fuel.
Excess savings built up during the pandemic have largely been spent, and inflation-adjusted wages are not high enough to sustain the spending levels we saw last year.
Low and middle-income households in particular are showing signs of financial stress. Car loans, consumer loans and credit card delinquencies have risen to above pre-pandemic levels.
While boosting homeowner wealth, rising house prices have taken a toll on discretionary spending. Until interest rates fall by enough to make loan payments more manageable and housing more affordable, we expect consumers to be increasingly cautious.
The labour market is returning to equilibrium…
Increased immigration and a rise in the labour participation rate have created an environment in which wage gains are declining even as job vacancies are rising.
We think this anomalous period is ending. The gap between job openings and the number of job seekers is closing, and the rate at which employees are quitting their jobs has slowed.
Unsurprisingly, the pace of wage growth has recently moderated as workers are less able to demand higher wages (see Exhibit 2).
Exhibit 2
Wage growth slows as workers stay in in their jobs
We expect wage growth to continue to fall as the labour market returns to balance. A downturn in hiring and an uptick in layoffs could put additional pressure on both wage growth and inflation.
…but inflation risks remain
Shelter cost inflation could rise if the shortage in rental units persists. Higher building and borrowing costs have cooled investment in housing just as more is needed to accommodate a growing population. Rapidly rising insurance premiums because of natural disasters and higher tax rates in some states have further doused the appetite for new construction.
The good news is that non-shelter services inflation should continue to moderate.
Even so, we think the ‘last mile’ of disinflation could be the hardest due to second-round effects. Also, exogenous factors abound, from conflict in the Suez Canal threatening global supply chains to the possibility of higher oil prices or a loosening of fiscal discipline in the US and Europe because of upcoming elections.
While the US presidential election is still four months away, the two leading candidates have signalled their comfort with a combination of higher spending, lower taxes, and higher tariffs – all of which could have a significant impact on inflation. A more restrictive immigration policy (supported by both candidates) could reduce the supply of labour, lifting wage growth.
Markets to date seem little concerned about these policies, but we expect the focus on fiscal policy to intensify as the quarter progresses and the election nears.
While inflation and rates should both decline in the months ahead, we think the risk that inflation rises – or at least stays high – is greater than the risk it falls faster than is priced into the market.
We maintain our view that Treasury yields are more likely to be volatile within a range of between 4.1% and 4.6% for benchmark 10-year Treasuries.
We encourage investors to be slightly more conservative than the consensus and note that the cost of protecting a portfolio against rising inflation is, in our view, curiously low. The market currently assumes that inflation averages around 2.3% over the next 10 years (see Exhibit 3). With the core Consumer Price Index currently at around 3.4%, this is a best-case scenario.
Exhibit 3
Breakeven inflation (US 10-year)
EU – The return of political risk
The results of the European Parliament election rattled markets, prompting an immediate flight to higher-quality bonds. Credit spreads widened sharply as did sovereign bonds spreads for France and ‘peripheral’ eurozone countries relative to German Bunds.
The political landscape has changed, and uncertainty has risen, meaning volatility is likely to remain high. If after the second-round parliamentary elections in France, the result is a less cooperative stance towards EU politics and policy, this could lift fragmentation or at least deter consolidation.
A more protectionist approach on strategic industrial sectors and key materials would likely disappoint investors, weighing on long-term growth expectations.
To date, economic growth has generally been holding up better than expected as higher inflation-adjusted disposable income has fuelled the consumer sector.
We expect both headline and core inflation to continue falling towards the ECB target and reach 2% next year, allowing the ECB to continue cutting interest rates. The ECB is currently forecast to cut rates by 25bp two more times this year (see Exhibit 4). We would see any significant deviation in market pricing from this as an opportunity to take a contrarian view.
Exhibit 4
Estimated number of additional 25bp cuts in ECB policy rate in 2024
We expect German Bunds to trade in a relatively tight range over the coming quarter and believe any significant widening in spreads for eurozone countries due to political uncertainty is likely to be an opportunity to add risk.
Though eurozone countries are strongly incentivised to comply with the EU fiscal framework, we would expect the eurozone yield curve would trade higher in sympathy with the US yield curve on concerns that any US inflation or fiscal deterioration could be exported.
Corporate bonds – Focus on the yield
Spread volatility has risen, but the fundamentals remain supportive. This justifies maintaining exposures for investors with a longer-term horizon. Demand for the asset class remains robust.
In our view, with yields in the eurozone currently at between 3%-4%, and near 5.5% in the US, the income from investment-grade credit is compelling (see Exhibit 5). We do not expect spreads to move significantly in the months ahead.
Exhibit 5
Compelling investment-grade corporate bond yields
Yields for investment-grade bonds are high by historical standards, and the resulting income can act as a significant buffer against elevated volatility weighing on bond prices.
In the US, the possibility of higher-for-longer rates should support corporate bond yields, though it could weigh on some sectors and companies.
Relative to investment-grade bonds, high-yield bonds remain attractive, in our view. Valuations may seem high, but they are based on a positive dynamic. Driven by the attractive yields, investor demand has met the higher issuance of new bonds, pushing back the 2025/2026 ‘maturity wall’. This should make the market more resilient to the risk of further delays in central bank rate cuts.
In this context, we believe high-yield default rates have likely peaked. Given that default risk concerns the most sensitive companies, it is important to be selective.
While election-related volatility has tempered our enthusiasm for eurozone IG bonds, we believe valuations are more attractive than those of US bonds.
Eurozone corporate fundamentals have remained good through the recent economic downturn and high cash levels should help companies weather any economic or political uncertainty.
Emerging market bonds – Stay invested, selectively
High yields for emerging market debt provide a competitive level of income and we believe that rebounding economies, declining interest rates, and stronger currencies mean the asset class offers a compelling opportunity for investors (see Exhibit 6).
Exhibit 6
Emerging market debt offers competitive levels of income
Emerging market index yields
The volatility that arises from elections may provide opportunities for active investors. In our view, focusing on a country’s path of economic growth and commitment to reforms can reveal attractive opportunities.
EM hard currency sovereign bonds offer spreads over equivalently rated US corporate bonds of more than 200bp. We expect supply to be restrained in the remainder of 2024 and into 2025.
Countries such as Egypt, Turkey, and Zambia have gone through a debt restructuring or negotiation of external financial support. Sri Lanka (which has yet to conclude its restructuring) and Ghana (which should finalise its restructuring ahead of the upcoming election) may offer potential upside. Even Argentina is likely to reward investors with constructive market reforms and positive headlines.
We believe EM corporate bonds are attractive relative to their US corporate peers, particularly for high-yield corporate bonds. Emerging market companies have in aggregate higher cash levels, comparable interest coverage ratios and lower leverage ratios. Additionally, as with EM government bonds, we expect the supply of corporate bonds to remain relatively modest into 2025.
As certain segments look more expensive, notably within IG, we see greater opportunities within frontier markets.
EM local currency bonds have fallen in price recently, even though the fundamentals are supportive. We are constructive on both currency appreciation and falling bond yields. Valuations, in our view, are attractive in Latin America and most of the EMEA region, while opportunities in Asia are more muted given the delayed easing cycle in South Korea, India and the Philippines.
Equities – Emergence of divergence
Renewed hopes that the Fed will be able to cut rates by more or sooner may yet be disappointed. June inflation could turn out to be closer to the level earlier in the year, and the increased odds of a Trump victory in November make it marginally less likely the Fed will cut rates this year, in our view.
Were this scenario to play out, some of the NASDAQ’s gain in June could be given back, but we are still confident in the medium-term outlook for earnings. Valuations are less of a concern for the NASDAQ than for other parts of the US market. The combination of a positive earnings outlook and reasonable valuations explains why our multi-asset team is overweight NASDAQ.
In our view, the risks to continued positive performance for US equities are more likely to materialise next year. Earnings may not rise by as much as analysts currently expect (forecasts today are for 18.8% year-on-year earnings growth in 2025 vs. 2024 for NASDAQ, and 13.3% for Russell Value).
Correlations across markets were high, but more recently, idiosyncratic factors have begun to matter. In the US, low inflation has lifted growth stocks, while inflation has been stickier in Europe. Political risk is higher currently in Europe, and recent economic data has disappointed. However, the region’s unemployment rate is historically low and wage gains have outpaced those in the US (see Exhibit 7).
We believe consumer consumption will improve, particularly now that the ECB has begun cutting policy rates. As a result, our multi-asset team has an overweight to the eurozone small-cap index versus large cap as greater household demand should disproportionately benefit domestically oriented companies. Valuations are attractive, with the relative P/E ratio below the long-run average.
Japan and China have delivered wildly different outcomes for investors this year. Japan has delivered the best returns of the top-five largest equity markets after the US, while China has delivered the worst. The gains in Japanese equities have been driven meaningfully by the weakening yen. That deprecation had stalled, and along with it the relative outperformance of Japanese equities (see Exhibit 8).
Exhibit 8
Japanese equities have lagged over the last two months
As for the MSCI China index, after three years of Covid-related weakness, it seemed reasonable to expect a sustained, outsized increase in corporate profits and hence in stock prices. Instead, earnings expectations have stagnated amid US tariffs and import restrictions, investor disappointment in government policy, and the drag from the property market.
The upcoming Third Plenum may be a catalyst for market gains, though it would likely require news of particularly robust stimulus measures for the economy, something we do not anticipate.
This report includes contributions from Cedric Scholtes, Head of Global Sovereigns, Inflation & Rates; Alberto Talero, Portfolio Manager, Euro Sovereigns; Christophe Auvity, Head of Global Corporate Credit; and Alaa Bushehri, Head of Emerging Market Debt.
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