Last week was a good one for equity markets with global equities up 3.4% in local currency terms and 2.5% in sterling terms. This left the comparable gains over the first quarter at 7.0% and 4.3% respectively. As for bonds, government yields rose 0.1-0.2% but in most cases this still left them down around 0.3% year-to-date.
These latest moves reflected a further easing in concerns over the banking sector. There was no real news but the absence of any new nasty surprise was itself viewed as encouraging.
Last week’s commentary was entitled Murky Waters. With the first quarter now at an end and markets back in rather calmer mood, now seems a good time to try and shed some light on the gloom.
There are really four key questions: How quickly and far will inflation fall? How soon will interest rates be cut? Are we heading into recession? Will corporate earnings hold up? The outlook varies to some extent by country but as ever it is the outlook for the US which is most important and so is the main focus below.
How quickly and far will inflation decline? Headline inflation has fallen back markedly from recent highs in the US and Eurozone, although not yet in the UK. The core rate, by contrast, has yet to slow significantly and is still running at 5.5-6% in all three regions.
Headline inflation should ease considerably further over the coming year, even if the decline will be slowed a little by the 4-5% bounce in crude oil prices triggered by OPEC’s surprise decision on Sunday to cut output by 1.1mn bpd. More importantly, underlying inflation pressures are likely to moderate only slowly and remain significantly above the 2% targeted by central banks. Wage growth is the most important factor here and should remain elevated as labour markets remain tight.
How soon will interest rates be cut? Market expectations have retreated considerably from the highs reached in February and it is now only pricing in one more 0.25% increase in the US with rates being 0.5-0.75% lower by year-end.
Rates look set to remain higher for longer than the market now expects. For one, the Fed is still adamant that it is not planning to cut rates this year. If core inflation does remain well above target, this should make the Fed, and also the BOE and ECB, slower to ease policy than normal in the face of a recession.
Are we heading into recession? Various tried and trusted indicators, most notably the inverted bond yield curve, suggest the answer is yes. However, there is as yet no concrete sign of a downturn and business confidence has recovered significantly in recent months. The latest banking problems pose a new economic drag but will be mitigated by the Fed not raising rates as much as it would otherwise have done.
Our view is that monetary tightening could well push the West into recession later this year but only a mild one. Consumers and corporates are in good shape, banking issues should be contained and the recovery underway in China is a support.
Will corporate earnings hold up? The fourth quarter saw US earnings fall 3%, the first decline since the pandemic, but the consensus is looking for earnings to be back growing at 10% by year-end. This looks decidedly optimistic. Margins are already under pressure and likely to remain so, with growth set to weaken and price inflation slowing faster than wage gains.
Where does this all leave us? We believe equities face some downside risk near term due to these overly optimistic earnings expectations and valuations which are on the high side. Against that, equities will continue to receive support from the prospect of rate cuts down the road and have upside potential further out, particularly outside the US.
As regards bonds, there are some potential headwinds short term from renewed upward pressure on government yields and a widening in corporate spreads. But fixed income is now offering the highest returns for over a decade and yields have scope to decline longer term.
We believe this all warrants being broadly neutral versus benchmark in terms of equity and bond allocations. Within equities, our view remains that the US will underperform going forward as its high valuations will be not supported by the super-low interest rates of the past decade. Within bonds, we continue to move away from our very cautious positioning of the last few years, both diversifying our holdings and lengthening their average maturity.
The views above are an attempt to shine a light on the current murky waters. But the heightened uncertainties at the moment and the recent sizeable forecasting misses by even the great and the good means now looks the time for a certain humility and caution in one’s positioning.
Rupert Thompson – Chief Economist