Hope springs eternal for investors who seem to sense a more supportive outlook for risk. The S&P 500 index has now rallied by over 20% from its low last October. Risk premia associated with US credit spreads, equities and volatility have fallen over the past week. In our view, risk appetite appears unduly high. We see a more defensive exposure as being warranted.
Fed’s pause gives food for thought
Investors have continued to mull over the pause in tightening monetary policy announced by the US Federal Reserve after 10 consecutive rate hikes. Data published in the wake of the Fed’s meeting showed a strong fall in the University of Michigan consumer inflation expectations.
Expectations for year-ahead inflation fell from 4.2% in May to 3.2% in June, suggesting consumer concerns over sticky inflation are easing. Long-run inflation expectations eased slightly from 3.1% in May to 3% in June. This data supports the case for the Fed’s recent pause.
That said, the Fed’s latest ‘dot plot’ of projections by policymakers showed a strong consensus that two more rate hikes would be needed this year to help bring inflation down to its 2% target.
Fed Chair Powell did play down some of the dot plot’s hawkishness in his press conference on 14June, after the meeting of the Federal Open Markets Committee (FOMC).
Subsequently, on 21 June, in the first part of his semiannual congressional testimony, Powell again offered a balanced message which markets are likely to interprete as meaning the end of the tightening cycle is near. His comments were broadly similar to those he made during his June post-FOMC press conference. He did not take the opportunity to adopt a more hawkish tone.
Our macroeconomic research team expects one more rate increase from the Fed, taking the fed funds rate to 5.50% in July. They expect rate cuts to start in December and accelerate in early 2024 as the US economy enters a mild recession.
ECB is still hawkish
As expected, the European Central Bank last week raised its key lending rate to 3.50% from 3.25%. It would have been an uneventful meeting of the Governing Council if it hadn’t been for the forecasts.
The ECB upgraded its core inflation forecast by 0.5% for 2024 and raised the forecast for headline inflation to 2.2% in 2025. Unit labour costs appear to be driving these changes, suggesting some stickiness in this forecast. It’s questionable whether the ECB’s view on core inflation is likely to change by September.
As a result, some observers consider their previous expectation of one more hike in July to now be a ‘floor’ for rates. They have raised their forecast for the terminal rate this cycle to 4%, with a further 25bp increase likely in September.
Our macro team sees the ECB hiking once more in July to a 3.75% terminal rate and then cutting rates from the first quarter of 2024.
UK inflation again surprises to the upside
The Bank of England’s (BoE) monetary policy committee (MPC) met on 22 June, with financial markets expecting a 25bp rate hike. A hawkish stance was expected, and the BoE duly delivered. It raised its key interest rate by 50bp to 5%, marking the highest level since 2008.
It’s likely that the language of the minutes and likely subsequent communications will reaffirm the MPC’s willingness to act decisively and suggest that further tightening is in the offing. Prior to the MPC meeting, markets had indicated that a slim majority of investors expected a quarter-point rate rise, although the likelihood of a 0.50% rise had risen after the latest evidence of stubbornly high UK inflation.
UK data for May, published on 21 June, showed inflation remained higher than expected for a fourth consecutive month. Consumer price inflation (CPI) rose by 8.7% in May, the same as in April. Core inflation, excluding food and energy, accelerated unexpectedly to 7.1% from 6.8%.
This significant rise in core inflation was unexpected and pushed the MPC to deliver a 50bp move.
Bank of Japan sits pat on yield curve control
The BoJ passed on the opportunity to tweak its yield curve control at last week’s policy meeting, but with Japanese inflation remaining high, the central bank will probably revise upwards its full year 2023 inflation forecast, from 1.8% to around 2.5% in its July report.
This means the next BoJ meeting is likely to be ‘live’, with markets expecting that higher inflation forecasts will be accompanied by a hike in the 10-year Japanese government bond (JGB) yield curve control ceiling, from 0.5% to 1.0%.
Elsewhere in Asia, China’s State Council meeting on 16 June did not provide any details on possible stimulus for a weakening economy. There was only a statement of intent to introduce more ‘forceful’ measures. A more comprehensive package may have to wait until the Politburo meeting in late July/early August.
Few tech stocks fuel US equity rise
In US equities, the technology sector continues to see strong inflows. The sector remains a favourite among investors, with large-cap tech the main driver of the narrow-breadth rally in US equities this year.
As a result, the three-month performance of the S&P 500 against the S&P Equal Weighted index has reached record highs. This suggests positioning in the sector could be stretched.
Tech inflows drove strong aggregate fund inflows into North American equities, while Europe lags behind after 13 weeks of consecutive outflows.
Investors reaching for risk
Investors seem to sense a more supportive outlook for risk. The S&P 500 has now risen by more than 20% from last October’s low (see Exhibit 1). Indeed, risk premia associated with US credit spreads, equities and volatility have compressed over the past week.
In the view of our multi-asset portfolio management team, investor risk appetite is close to extreme risk-seeking territory, suggesting a more defensive exposure is warranted.
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