Authors: Weiheng Chen, Julia Wang, Cameron Chui, Yuxuan Tang
An eventful week in markets hit its high note with the June U.S. CPI release, which indicated a broad-based softening in inflation. The headline number was up 0.2% m/m, and just 3.0% y/y, the lowest since March 2021. Core CPI grew 0.2% m/m and 4.8% y/y, the lowest since October 2021. Shelter was a key contributor, though that category has also continued decelerating. The Fed’s preferred “supercore” inflation measure, which is core services excluding shelter, has been trending down to around 3%, and is a key cut of the data for tracking the impact of the labor market on inflation. Treasury yields declined sharply in the wake of the report, with the 10-year falling over 20bps from its peak above 4% last week, while the 2-year moved even more violently from over 5.0% to 4.7% in the same time. The dollar also sold off, with the DXY declining nearly 3%. Stocks rode the good news, up around 2% from lows last week. As the all-important debate between a recession and soft landing rages on, it appears “soft landing” has scored a big hit for now.
The global economy is still clearly dealing with the aftermath of Covid-era distortions, making for a business cycle that’s never been harder to analyze. As we head into the second half of the year, here are the top questions from our mid-year outlook, and our thoughts on how to position for an unpredictable cycle.
Will the Fed keep hiking rates?
That largely depends on which path the U.S. economy is more likely to take: a recession or a soft landing. Consensus assigns a 65% probability of recession over the next 12 months, as they have all year. Nonetheless, the economy is proving to be more resilient to Fed tightening than we anticipated, particularly the job market – with the last 3-month payroll gains averaging over 200K jobs per month and home building, which has bounced recently. However, the Fed has been tightening policy for 18 months now and the lagged impact on the economy is showing up: 1) Equipment capex spending is slightly negative year-over-year, with tight lending standards signaling further weakness ahead; 2) Consumer credit card delinquencies are inflecting higher, albeit from a low level; 3) Labor demand is slowing. The unemployment rate and initial jobless claims, while near historic lows, have ticked up.
Our base case is consensus: a U.S. economic contraction starting around the end of the year. Given the low levels of leverage in the economy relative to pre-Global Financial Crisis (GFC), we continue to see little evidence of a pending financial crisis. Rather, we expect a monetary policy-driven slowdown.
The Fed is managing the tradeoff between growth/employment and inflation; namely slowing growth just enough to bring inflation down to target. On the optimistic side, recent inflation readings have been lower than we expected without labor market weakness – suggesting the Fed may not need to push growth as low as previously expected to bring inflation down. Fed Chair Powell’s preferred measure of trend inflation – core services ex-shelter – has cooled of late (3% annualized vs. 5% three months ago). On the pessimistic side, the recent bounce in U.S. housing starts and sales and easing financial conditions (equities up and credit spreads down) suggest the disinflation process may not return inflation all the way to 2% (or worse, inflation could pick up) – suggesting the Fed may need to push growth even lower than previously expected to bring inflation down. Also encouraging the risk management approach is persistent inflation globally. We continue to expect the last Fed rate hike in July, with the risk of further hikes declining on the margin with the softer CPI print.
Yields tend to offer substantive cushions should investors miss the ideal entry point. U.S. investment grade yields would have to rise more than 80bps for an investor to have a negative total return over a 12-month period. That said, expected terminal Fed funds rates and longer-duration Treasuries have been highly correlated during this hiking cycle. For investors looking to add duration more tactically, that relationship suggests an expected terminal rate of 5.3% (one more hike) is consistent with 3.8% for 10-year Treasuries. For every additional expected 25bps of hikes, the implied yield for 10-year Treasuries increases by around 18bps.
Is China’s recovery stalling?
China’s growth recovery has been a bumpy one. Notably, activity slowed quite meaningfully over Q2 in a broad-based manner. Part of the slowdown was payback from some earlier front-loading of orders. The good news is that as we look ahead to 2H, this could pose less of a drag. In fact, we think the bulk of the sequential slowdown is behind us, and sequential growth will likely bottom out in 2H. This could translate into a gradual recovery in headline activity data. In the very near-term, data could remain on the weak side. Leading indicators such as PMIs point to a slowdown in new orders and subdued expectations in July.
But we expect more recovery later in the year. Key to our thesis is the service sector, which we believe could drive a more self-sustained recovery. Services were badly hit during Covid, and have rebounded strongly, but there is still more room for it to play out. As capacity utilization improves, we expect demand for labor could increase. An improvement in the labor market can translate into a better income outlook, it could help to reduce precautionary savings, and also further support consumption. This could have a positive spillover on the manufacturing sector, particularly as inventories have already reached multi-year lows. Chinese markets are likely to be range-bound in the near term, but with more upside potential when the growth path becomes clearer.
As for policy, we think the priority is stability rather than stimulus. Recent pressures on local governments mean reduced fiscal space. We are not expecting the central government to step in with a big policy bazooka to help. Instead fiscal support will likely be quite targeted as usual, and focus on industries like electric vehicles and household white goods. On monetary policy, some further incremental rate cuts are likely but the overall pace and magnitude will likely be limited, especially considering the need to maintain stable expectations on the currency as well as banks. This could translate into near-term stability for the RMB (at around 7.0-7.2), with some risks of further weakness if the interest rate differential versus the U.S. stays wide or widens further, instead of narrowing next year. We prefer to use the RMB as a funding currency rather than position for further outright weakness. In contrast with the developed world, the RMB interest rate is biased lower for longer.
Read more in our article here.
U.S. equities are up a lot, why should I be buying now?
While U.S. equities have staged a strong rally in 2023 and offer only modest upside to our June 2024 S&P 500 outlook of 4,450-4,550, the move higher is highly concentrated in a handful of 6-7 stocks. From here, we suspect the rally in U.S. equities will likely need to see broader participation from the 493-494 stocks that collectively are only up by low single digits this year. One way to highlight this differential is the relative price/earnings ratio for the equally weighted S&P 500 and the S&P 500 (market cap weighted), which is near record lows. We believe that there is significant scope for the performance of these indices to narrow, with equity structures well-placed to capture this view. In addition, we continue to see plentiful thematic and single stock opportunities that highlight the growing importance of alpha over beta in the U.S. equity market.
Can Japan continue rallying?
As Japan’s post-pandemic recovery continues, inflation could stay elevated and augment long-held behaviors and mindsets. Even as expectations for a shift from the BoJ have fallen, we continue to see some strength for the currency based on potentially lower U.S. Treasury yields. While we still think the yen could strengthen from here, without help from the BoJ the move would be only driven by lower USD yields, implying a smaller upside potential. Our current outlook for 10-year Treasury yields implies USDJPY at 135 and 130 for year-end and mid-2024 respectively. Japanese equity markets remain fully valued and we are firmly neutral on the broad market at this juncture. That said, we continue to find individual alpha opportunities that have meaningfully lagged the market across a number of sub-sectors linked to the domestic economic recovery and select names in the semiconductor industry. With volatility elevated, equity structures with upside participation and meaningful downside protection are a preferred approach for clients who would like to increase their allocation in Japanese equities.
Read more in our article here.
Should I buy gold?
We remain bullish on gold both given where we are in the cycle and from a longer term strategic perspective. Real rates and the strength of the USD are usually regarded as key drivers of gold prices through the cycle, and both seem to be supportive from here. Rates will likely move lower over the medium-term as we continue into the late cycle with the Fed getting closer to a pause. The USD has clearly peaked and will likely continue to unwind its excessive overvaluations built up last year. In addition, gold has been clearly demonstrating its safe haven characteristics this year by responding strongly to U.S. regional bank turbulence and the debt ceiling, which is appreciated by markets in a late cycle environment.
Over the longer term, gold can add diversification benefits to portfolios. In particular, it could serve as an effective hedge to some of the top concerns for long-term investors. Many are worried about rising geopolitical tensions globally, as well as structurally higher and more volatile inflation in the developed world, while finding these risks difficult to address in portfolios. Here, what central banks are doing could be instructive. In recent years we saw strong purchases from central banks around the world, some of which, including China, Russia and Turkey, have been accumulating gold reserves at a record pace. According to the World Gold Council, 24% of central banks plan to increase their gold holdings in the next 12 months. Investors may consider adding on dips in cash or via structures to take advantage of volatility in the market.
Why should I still invest into alternatives now?
Despite the uncertainties that persist in the current market environment, we see a number of contrarian opportunities through private investments across equity, credit and real estate. Timing is interesting for medium to longer term investments, and we can capitalize on attractive entry valuation multiples and participate in secular growth areas. We advocate a diversified approach across strategies and geographies where opportunities arise due to temporary market dislocation. Private managers can generate alpha through active management as they depend less on market direction or beta. We are focused on three high conviction areas:
- Private credit: Interest rates will likely remain high in the immediate future, and large volumes of corporate credit are maturing within the next three years. Banks are potentially facing increased regulations and higher capital requirements and costs, resulting in less activity in syndicated bank loans and lower high yield bond issuance. Weak loan documentation and liquidity pressures in public debt markets may create opportunities for direct lenders to step in on a more senior basis.
- Growth private equity: We are exploring traditional private equity opportunities across venture capital, mid-market buyouts and secondary transactions. Valuations have declined around 30-50% in venture capital in the past 12 to 18 months. Although the correction could remain for a few more quarters, significant technological innovation continues to take place (such as in Artificial Intelligence), and we see opportunities in both software and hardware TMT (tech, media and communications) sectors. Based on similar market cycles in the past 30 years, we anticipate 2023-24 to be one of the most interesting vintage years to put capital to work in private equity.
- Fundamental equity hedge funds: Elevated dispersion in public equity markets has created a more interesting environment for fundamental equity hedge funds to generate alpha. Experienced fundamental long/short equity hedge fund managers can be a prudent way to gain exposure to a range-bound market. Markets could increasingly focus more on company fundamentals and cashflows, and equity hedge funds could generate alpha or idiosyncratic returns in both long and short positions.
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