The Sun is Back

September 13, 2023

In June, the sun started shining again on equity markets as it became clear that the global economy is not on the brink of a recession, while at the same time inflation is clearly moderating, which led to the Fed pausing its rate-hiking cycle.

The U.S. equity rally, which had been narrowly concentrated among tech stocks for most of the year, broadened in June with all equity sectors ending the month in the green. In fact, the U.S. market outperformed its global counterparts. Nevertheless, the equity rally was also broad-based across the major regions of the world.

The main exception is Chinese stocks which fell in USD terms amid ongoing CNY weakness. Investors think that Beijing’s recent stimulus efforts are not enough to generate a meaningful recovery in the Chinese economy. 

Meanwhile, global bond yields increased as major central banks maintained a hawkish policy stance. In particular, yields on U.S. 10-year Treasuries reached the highest point since the early March banking turmoil.

Going forward, continued central bank hawkishness is an upside risk to bond yields over the near-term. However, we expect that softer inflation will ultimately cap Treasury yields near current levels. At the same time, we think resilient economic conditions will support the equity rally over the coming months.

The recent equity market rally is taking many investors by surprise and some financial news articles argue that the equity market should not be going up while the global economy is weakening.

There are two major flaws with this logic. First, the global economy is still growing albeit at a lower growth rate. Some investors seem to confuse lower growth with a shrinking economy.

Secondly, equity markets are forward looking. That is why last year we experienced an equity bear market while inflation was accelerating, and the nominal economy and corporate earnings were growing nicely.

The day the equity market bottomed last October, was the same day U.S. Consumer Price Inflation peaked.

Wall Street’s logic is sometimes backwards. They feel that high inflation will cause the Fed to tighten too much and start a recession. We believe the large stimulus packages from the last 3 years have provided a cushion that makes consumers and businesses less interest rate sensitive. Therefore, rates can move higher and faster than in previous cycles. 

Moreover, we think that high inflation has increased corporate margins, as prices have moved faster than wages and other input costs. 

We expect inflation in the U.S. and most other economies to fall significantly over the coming months without much of an increase in unemployment. 

However, a recession could start in 2024, and if so, probably in the second half of the year, when investors least expect it. The jobs market – slowing but still growing today – could continue to weaken to a point that consumer spending and confidence will be impacted. 

The irony is that falling inflation could sow the seeds of its own demise. Since wages tend to be stickier than prices, falling price inflation can boost real wage growth, which in turn can boost spending and inflation.

Our baseline, however, is that it is more likely that demand will continue to soften to the point that the economy slips into recession next year without the need for substantially higher rates. This reflects the fact that monetary policy is already restrictive: as of May, the Fed was at 5% while inflation was at 4%, which means that inflation is lower than the cost of borrowing for the first time since COVID. In fact, at 1% difference, it is the highest positive real rate since September 2009.

Nevertheless, current inflation is still running hotter than the Fed prefers, and therefore another 25bps hike is highly likely at the FOMC July meeting.

We think the market has already discounted another rate hike and we don’t expect a big impact. What will be more important are second quarter corporate earnings. We expect to see another strong earnings season and earnings estimates should rise into the summer months thanks to firmer global growth. The rally in stocks should continue as inflation falls, growth remains resilient, and earnings recover.

What Happened to the Recession Expectations?

Normally, when labor demand falls but labor supply rises, unemployment goes up. That is what most strategists expected last year, and yet it did not happen. However, this is not a linear relationship. When the economy is at full employment, falling labor demand will mainly result in slower wage growth and lower job openings rather than lower employment. This is precisely what occurred. Job openings declined but in contrast to past episodes, unemployment barely rose. 

The idea that the U.S. economy could experience a soft landing becomes increasingly more plausible. Unfortunately, there is a twist in the story. When the Fed cools down the economy enough to reach its inflation target, it is highly unlikely the inflation rate will just sit at the Fed’s preferred rate of 2%. It is more likely that the economy and inflation will continue to soften at that point, until it falls into recession.

When will this day arrive? While it is impossible to be sure, we think that the next U.S. recession will not start until 2024, and probably not until the second half of that year. At the moment, there are simply not enough headwinds to trigger a recession.

Even the stress in the regional banking sector back in March has failed to make much of a dent in the economy. Only one percent of business owners reported that all their borrowing needs had not been satisfied. Banking lending to the business sector has largely stabilized since the turmoil in March.

The European Economy

After a brief rebound following the drop in gas prices, the European economy has softened again. While services have generally held up well, manufacturing has weakened. If global manufacturing starts to recover in the second half of the year, this could generate some renewed growth momentum in Europe.

There is still considerable uncertainty about the energy situation in Europe going into next winter. Fortunately, Europe is much more energy independent now than it was this time last year thanks to significant investment in new gas pipelines, LNG terminals, and the securing of new sources of supply.

China

After a growth spurt following the post-Covid reopening, China’s economy finds itself on the back foot again. As a major exporter of manufactured goods, the downturn in global manufacturing demand is weighing on activity. While the manufacturing headwind may fade over the coming months, another headwind is likely to persist: housing. In many ways, China’s housing market resembles the Japanese property market of the early 1990s. Like Japan back then, China’s housing market is overvalued and plagued by overbuilding and an excess of debt.

While China’s growth data disappointed in recent months, this looks different when viewed in a global context. While recent data points did miss market expectations, the disappointment was off high expectations set by the market itself. 

Looking beyond the underperformance of those expectations, the data was not at all bad by global standards. China is still on track to meet the Government’s “around 5%” GDP growth target for this year. 

A key reason is that while manufacturing is struggling, China retail sales are still strong with a year-over-year growth of 18.4%. The greater role of the Chinese consumer in driving growth is important to create a more resilient domestic economy.

It is likely that China’s economy will achieve reasonable growth for the remainder of the year. Such a Goldilocks outcome is probably optimal for the rest of the global economy – not so hot as to stoke global inflation but not so cool as to produce an imminent recession. And given the valuation of Chinese stocks, along with the wrapping up of investigations into internet companies, we think the long-term prospects remain attractive, especially for consumer companies.

Equity Market Optimism

At the start of 2023, many Wall Street strategists expected equities to decline on the year. Against such a backdrop, it is not surprising that stocks were able to climb the proverbial wall of worry. What is striking is that while equity sentiment has improved over the past few months, many investors remain cautious. 

In fact, fund managers in the BofA Global Fund Manager Survey were underweight equities in June. If fund managers now have to adjust their positioning so that it matches their newfound optimism, they will need to buy shares, supporting stock markets.

Earnings Are Rebounding 

There is a fairly consistent relationship between earnings revisions and economic surprise indices. When the economic data surprise on the upside, analysts typically revise up their earnings estimates. After declining for eight straight months, 12-month forward earnings estimates began to rise in February and are now up 2.5% from their lows.

U.S. margins are still high by historic standards and could decline during the next recession. However, until that day arrives, margins are likely to remain stable. With sales still growing, this means that earnings will continue to rise, providing near-term support to stocks.

We currently favor international markets over the U.S. We like the Euro area and Japan. Both regions have seen positive earnings and sales momentum, and both would benefit from a rebound in global manufacturing. They are also reasonably cheap – trading at 12.2 and 14.9-times forward earnings, respectively, compared to 19.4-times for the U.S., while at the same time there is the potential for a rerating of their currencies.

Fixed Income

Until the next recession arrives, bond yields will be stuck in a tug of war between falling inflation on the one hand, and a still resilient economy on the other hand. We recommend that clients maintain a neutral-to-short duration position for the time being but look to increase duration exposure to above-benchmark later this year once the economy cools some more.

Bullish on the Yen

If other central banks start cutting rates next year as the global economy falls into recession, interest-rate differentials will move in favor of Japan. The yen is arguably an even more defensive currency than the U.S. dollar, and hence it would benefit from a risk-off environment. The yen is also very cheap, trading 40% below its Purchasing Power Parity exchange rate, the biggest discount of any major currency. Lastly, while it may not happen immediately, the Bank of Japan will eventually dismantle its Yield Curve Control system, resulting in higher Japanese bond yields and a stronger yen.

Upside for Oil and Metals

If global growth surprises positively over the remainder of 2023, as we expect, oil and industrial metal prices should strengthen. Tight supply conditions should further support prices. In the metals complex, new capital investment has been weak. Metals inventories remain at exceptionally low levels. In many countries, political uncertainty continues to hamper investment. 

Globally, capital spending per barrel of oil produced is down two-thirds from its peak. Most oil companies continue to prioritize returning cash to shareholders over new investment. Partly, this is due to the fact that the longer-term demand outlook for oil is less positive as the world rapidly shifts to electric vehicles. However, for the foreseeable future the world still needs oil.

Portfolio Positioning

In June our portfolio positions performed well. Quality stocks continued to outperform but in June it was not only the mega caps but also small and mid-cap stocks that rallied substantially.

Overall, the portfolios are well-positioned to profit from the market recovery, while also being well-diversified to deal with short-term volatility.

DISCLAIMERS & DEFINITIONS

This material represents an assessment of the market and economic environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results.

Forward-looking statements are subject to certain risks and uncertainties. Actual results, performance, or achievements may differ materially from those expressed or implied. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Past performance does not guarantee future results.

Investing internationally carries additional risks such as differences in financial reporting, currency exchange risk, as well as economic and political risk unique to the specific country. This may result in greater share price volatility. Shares, when sold, may be worth more or less than their original cost.

The Consumer Price Index (CPI) is a measure of inflation compiled by the US Bureau of Labor Studies.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks, including changes in credit quality, liquidity, prepayments, and other factors. REIT risks include changes in real estate values and property taxes, interest rates, cash flow of underlying real estate assets, supply and demand, and the management skill and creditworthiness of the issuer.

Investments in commodities may have greater volatility than investments in traditional securities, particularly if the instruments involve leverage. The value of commodity-linked derivative instruments may be affected by changes in overall market movements, commodity index volatility, changes in interest rates or factors affecting a particular industry or commodity, such as drought, floods, weather, livestock disease, embargoes, tariffs and international economic, political and regulatory developments. Use of leveraged commodity-linked derivatives creates an opportunity for increased return but, at the same time, creates the possibility for greater loss.

Neither Asset Allocation nor Diversification guarantee a profit or protect against a loss in a declining market. They are methods used to help manage investment risk.