After recent higher-than-expected US inflation, we see core inflation cooling only in 2025 and expect policy rate cuts to begin only in the fourth quarter. Our view is that a soft landing by the US economy is still likely and that growth will remain above trend through 2025.
One might have thought that four years after the start of the pandemic, investors might have some confidence in the outlook for economic growth and inflation. Unfortunately, that is not the case.
The long series of mostly upside surprises to inflation from 2020 to 2022 was followed by more predictable (and falling) inflation last year, leading to a strong consensus view for an economic ‘soft landing’ in the US.
The start of 2024, however, has seen three months in a row of higher-than-expected inflation (see Exhibit 1).
Given the persistence of inflation, the question then became whether it would be accompanied by robust growth — raising the risk of a newly overheating economy — or by slower growth and a potentially stagflationary outlook.
February retail sales and March non-farm payrolls supported the first scenario, and expectations for the number of times the US Federal Reserve (Fed) would cut policy rates this year fell to close to zero. Benchmark US 10-year Treasury yields rose to 4.7%.
Subsequent data, however, has pointed to unexpectedly slower growth beginning with US GDP (1.6% versus 2.2% forecast), followed by purchasing manager indices (1-3 points below forecast for the Institute of Supply Management series, and levels below 50, indicating contraction), and finally private, non-farm payrolls, which came in 60 000 jobs (seasonally adjusted) below consensus estimates.
A good slowdown
This slowdown is encouraging, insofar as inflation is unlikely to decelerate without it. How quickly that happens, and how far the slowdown needs to go, is the key worry for investors. Our view is that the soft landing has not been aborted, only delayed, and that growth will remain above the long-run trend rate of 1.8% through next year.
While monthly core inflation has been high, the year-on-year change in the personal consumption expenditures index (PCE), the measure favoured by the Fed, is still declining and currently stands at 2.8%. The Fed’s forecast for the end of the year is 2.6%.
We do still anticipate the Fed will cut rates by the end of the year, with more to follow in 2025. Markets currently place around a 50% probability of a cut as soon as September. Treasury yields have fallen back towards 4.4%.
The Fed itself seemed to endorse the view that a soft landing was still in sight. At the most recent press conference, Fed Chair Powell pushed back against the idea that the bank might need to increase policy rates, pointing out that they are already restrictive and sufficiently high to do the job.
Equity market reaction
The increase in interest rates (particularly real yields) that we had seen until recently has had the predictable effect of weighing on equity market prices, particularly growth stocks: the NASDAQ 100 is 1.3% off its peak from late March (as of 7 May 2024).
Given the size of the increase in yields, however, one might have expected a bigger decrease in equity prices. What has sustained the market has been a good earnings season, both for US and European equities.
The NASDAQ 100 was expected to see a double-digit year-on-year increase in earnings for the first quarter, while a decline was foreseen for the Russell Value index. Earnings for companies in the MSCI Europe index were also forecast to drop. The results so far have been better. Earnings surprises have been 6-9%, when a typical quarter sees results only 3-4% higher than forecast (see Exhibit 2).
Assuming the policy rate expectations (and real yields) do not move much higher, earnings should remain the primary driver of equity indices. And if the slowdown in economic growth does not go too far, earnings should continue to rise.
China
Data for China has shown ongoing resilient growth, supported by demand for the country’s exports and holiday-related travel activity. These positive factors are being offset, however, by the drag from weak property investment. The Chinese government is aware of the risks, and we anticipate policy support will be stepped up in the coming months. Fiscal support is likely to be the key tool, and this may be used sooner rather than later.
Already since the ‘two session’ conference in March, equity markets have staged an impressive rally; the MSCI China index has outperformed global equities by 14% since the end of March.
A recovery in valuations has been the primary driver. Prior to the rally, the relative forward price-earnings ratio of the MSCI China index versus developed market equities had fallen to two standard deviations below average; it has now recovered to 1.3x, still leaving a lot of scope for a further revaluation of the market.
Earnings expectations, however, have not (yet) played much of a role. Over the last year, forward earnings per share (EPS) estimates for companies in the MSCI China have not changed, in contrast to those in most other major market indices (see Exhibit 3). To the degree that foreign investor sentiment on China is beginning to recover (or at least not weaken further), valuations could (partially) normalise, but eventually earnings will need to take over as the motor for price appreciation.
Technology sector
The increase in earnings expectations for the NASDAQ 100 index shown in Exhibit 3 reflects the immediate impact of increased investment in the semiconductor industry thanks to the US CHIPS Act, spending on artificial intelligence (AI) model development, and anticipated earnings from AI as companies learn how to use the technology to increase revenues and/or reduce costs.
This increase has not been limited to the ‘Magnificent 7’ stocks. Forward earnings expectations have risen by 18% over the last year for the index excluding the Mag 7. While forecasts in our view are unlikely to continue rising at the same rate from now on (though there is no sign yet of a deceleration), they will nonetheless likely outpace those for other parts of the market (as represented by the Russell Value index), or those of other countries.
Alongside this positive earnings outlook, valuations are reasonable, especially now that prices have fallen slightly while earnings expectations have continued to rise. The forward price- earnings ratio for the NASDAQ 100 today is one of the least expensive major markets (see Exhibit 4).
As we have already seen this year, were inflation to again come in stronger than expected and policy rate forecasts to rise, valuations and prices would fall back, but the positive earnings trend should eventually reassert itself.
Asset class views
Recent changes
MULTI-ASSET
- Going long Japanese equities, where both fundamentals and valuations are appealing. Japan stands out as the only area where expected earnings have increased as the market has rallied, preserving a 15% forward price-earnings (P/E) and 50% forward price-book (P/B) discount to global stocks.
- Implementing a modest tactical long to domestic China, where valuations are extremely depressed and where triggers for unlocking this value – in the form of policy support and incipient manufacturing recovery – are increasingly present.
- Closure of our European equity short, where bad news may be baked into current prices and expectations, and economic data is increasingly surprising positively. Germany is an outlier. With a more constructive bottom-up picture following last year’s earnings recession, we turn neutral. We also closed our relative-value trade – long UK, short Europe – as part of this.
- Reducing our long US TIPS exposure: on strong rallies, and as the growth-inflation narrative shifts.
- As a result, we are now mildly overweight select equities (by around 2%), but with long duration remaining our largest risk position. Risk taking remains in the second quintile relative to the maximum.
FIXED INCOME
- Rate cuts are on the agenda in 2024 in the US and within eurozone, but central bankers have tried to push back the presumption of an imminent cut in key rates. We do expect June to be the start the first round of cuts.
- Following the recent increase in rates, we increased our exposure towards duration to an overweight. We do prefer euro duration versus the US duration. We still prefer the 0-3 years segment that could benefit from this context.
- We expect the curve to steepen as cuts emerge at a time where supply may put additional pressure on the long end.
- With low growth in Europe, high-yield spreads appear stretched to us and we do consider emerging market debts in hard currency to be more resilient in this context.
EQUITIES
- We have a constructive view on global equities for 2024 underpinned by strong fundamentals with:
- Earnings recovery: earnings growth is set to resume in 2024 with consensus seeing double digit earnings growth in the US market. This comes after near 0% growth in 2023 and importantly, more sectors are seeing a pick-up in EPS grow from 2023 leading to a broadening of leadership. Indeed, the post COVID years have been characterised by de-synchronisation between goods and services. We saw stark divergences in various end markets with, for instance, a healthy recovery in air travel while rail volumes were still depressed owing in part to inventory normalisation in goods.
- Stronger economic growth: US GDP growth has been surprising to the upside with the Fed recently revising its forecasts for 2024.
- This very much looks like a goldilocks scenario for equities but note that while recession risk has been reduced, geopolitical risk remains elevated. As such, we have been marginally adding to beta in our portfolio: it is now slightly higher than one. We are adding to small and mid-cap stocks, which should benefit from better economic prospects. Regionally, we prefer the US and Japan where earnings growth is stronger.
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