The narrative of ‘immaculate goldilocks’– rising growth and falling inflation – was always at risk of being challenged in the first half of 2024 – more likely from stickier inflation in the US rather than weaker growth. And so it has been. Above-trend growth in the US and the significant boost to inflation from one-offs have challenged the tale of sustained price depreciation.
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There are numerous threats to US economic growth in the quarters ahead:
- If inflation stays high, high real interest rates could eventually curtail activity more so than we have seen so far, particularly as excess consumer savings run out.
- Any more unpleasant surprises from US regional banks due to problems in the commercial real estate sector would not help.
- The cost of credit has soared for consumers and companies, US federal fiscal support is waning, and election risks are running high.
Outside of the US, things look more balanced. For the eurozone, the risks are for modestly better growth, excluding Germany. Recent data has surpassed slowly improving consensus expectations, labour markets have remained firm, and business and consumer survey data appears to be turning up.
For the UK, we see a modestly positive outlook from a low starting point for growth. Recent data has been better for manufacturing and housing. Consumer and retail sales data has improved, and inflation has stopped falling. Forward earnings expectations have remained steady.
And although headline Japanese macroeconomic data has been weaker, the corporate sector has found a sweet spot.
Adding to equities
Japanese stocks appear to be in a ‘sweet spot’, offering investors exposure to preferred sectoral and secular themes underpinned by a strong structural reform story and attractive prices. Both fundamentals and valuations look supportive, notwithstanding the strong rally in the Japanese market this year.
To be sure, as earnings have continued to grow (well ahead of what might be explained by currency moves), Japanese equities have broadly preserved their valuation appeal, trading at a 15% forward price/earnings discount to global equities and a 50% discount on forward price-to-book and forward price-to-sales ratios. Since our last monthly, we have added to Japanese equities on weakness.
By contrast, although Chinese earnings expectations have yet to rise, green shoots in global manufacturing should benefit manufacturing-heavy, operationally levered and attractively valued areas such as emerging Asia, with an additional boost from domestic Chinese policy support.
The widening gap – Shorting the Swiss franc against the yen
We switched our long exposure to the Japanese yen (JPY) versus the euro, which had been costly in carry terms, to a long versus the Swiss franc (CHF), considered an ‘alpha proxy’ for the EUR. JPY/CHF valuations sit at multi-decade extremes across a host of metrics, and the Swiss central bank has begun cutting rates in line with our economists’ expectations, and against the consensus.
Notably, the Bank of Japan started a rate hiking cycle (after decades of loose monetary policy) in the same week that the SNB began easing. Rate differentials could widen further since both central banks are on record as indicating that currency market intervention is possible: the SNB is keeping the option open to sell CHF and Japan’s Ministry of Finance is threatening purchases of JPY.
It is all gold that glimmers
Gold has rallied significantly since mid-February, but we have held our ground (our view: ‘favour’ precious metals; see table below) as market sentiment does not appear extreme, seasonality and historical analogues are positive, gold volatility is still low, and market positioning appears to be underwhelming.
Being overweight gold seeks to capture four positive factors:
- It is a hedge against a return of inflation
- It is a diversification asset for portfolios
- Real rates are falling
- It is a haven in an increasingly multi-polar world.
On the latter, central banks have purchased an average of 330 tonnes of gold per quarter since Russia invaded Ukraine more than two years ago. This is more than 2.5 times the quarterly average of the preceding decade.
Steepening yield curve in Germany
We have initiated a German 5-year/30-year steepener trade, expecting a bull steepening.
Weak German growth, combined with improving inflation data in the eurozone, suggests the ECB will lead the US Federal Reserve in cutting interest rates, lowering near-term bond yields. Timing is key, and trading two months ahead of the first policy move has been ideal historically.
In addition, the spread between 5-year and 30-year bonds captures similar initial moves in the spread between 2-year and 10-year bonds, but at a far less demanding cost of carry and roll.
Our asset class views
We made five shifts in our asset allocation in March and early April:
- Increased allocation to equity markets by neutralising our short position in European equity and adding to Japanese equities. Combined with our existing long in emerging Asian stocks, equities are mildly favoured in our asset allocation.
- Reduced long duration by cutting a third of our long position in US real yields after strong rallies in early March. We remain long duration by 0.5 years; long duration stood at between one and two years at the peak of our allocation in November.
- Put on European sovereign yield curve steepeners between the five and 30-year points on the German curve (duration neutral) as market expectations of a summer cut in ECB interest rates mount. Timing is key, and we believe a trade set up two months ahead of the first cut has highest efficacy.
- Unhedged our long Japanese equities position, taking a long JPY exposure alongside Japanese stocks as Japan’s negative interest rate policy ends. We have funded this in Swiss francs as a euro-proxy with an ‘alpha kicker’, that is, a more dovish Swiss National Bank. After the recent surprise cut in rates by the SNB, we added a standalone JPY/CHF position.
- Added and formalised a long gold position as a key hedge to inflation and with supportive fundamentals. Overall risk taking has been increased, towards the neutral quintile (for flexible multi-asset funds).
