Evan Brown Tiffany Gherlone Baxter Wasson Andy Strommen

Macro Outlook

Evan Brown, Head of Multi-Asset Strategy and Portfolio Manager

Bottom line: We continue to be of the view there will not be an imminent recession – but, as such, we expect inflation to remain sticky and elevated. While central bank tightening cycles are not done, they are slowing down. This should mean a decline in bond volatility, such that further rate hikes will have less of an impact on risky assets.

We are starting to see a shift in economic momentum towards the US as of late, and away from Europe and China. In our view, there is scope for more cyclically oriented US equities to bounce back.

There are two main differences between this business cycle and others: fortress private sector balance sheets (reinforced by large fiscal stimulus) and the divergence between goods and services spending. Coming out of COVID, we had a surge of demand in goods due to low mobility. Following a proper reopening, there was a switch to services that is still carrying through.

Normally in the business cycle, the goods sector is a key leading indicator for the broader economy but given we had this abnormal, pandemic-catalyzed boom in goods, the roll off of it hasn’t been a harbinger of recession.

Money is being spent in services, in areas where the labor market is still really tight. Initial and continuing jobless claims, which were rising last year, have stabilized. That is key for consumption to stay resilient.

We are seeing some green shoots in other areas of the economy. Housing, the most rate-sensitive part of the economy, got crushed last year amid surging interest rates, but homebuilder sentiment has rebounded, construction employment is rising, and there is structural demand from millennials while rate-locked households don’t want to move.

There have been a series of rolling recessions in different sectors, but not all at once. First was tech/crypto/VC, then housing, and now manufacturing is stalling. Later this year, there will likely be pressure on services but as that is weakening, we could see housing and manufacturing pick up again.

The main risk we see right now is a sharp tightening of lending standards. The question is how much bank stress will drive standards even tighter. At least for now, there appear to be few signs of a seizing up of credit, and broad financial conditions broadly are fairly easy. The Senior Loan Officer Survey showed recent bank tightening in lending was driven by concerns about the economic backdrop in general, rather than a lack of liquidity or capital adequacy.

In our view, the condition of credit markets, the Federal Reserve, and earnings will be the key drivers of risky assets. Treasury bill issuance following the debt ceiling deal may well reduce bank reserves, but we are still in an ample reserve position, in aggregate.

For inflation, we have made a lot of progress in getting headline price pressures down with the decline in energy prices and supply chain issues resolving. Now, shelter prices are coming off. But the Federal Reserve is most focused on core services ex-housing. This is the type of inflation that tends to get sticky and is tied to the labor market. It is still pretty elevated, and not close to the Fed’s target. Investors need to think about a soft landing versus no landing – no landing being a continuation of sticky services inflation as growth stays resilient. In that environment, the Fed probably has to continue hiking – possibly eventually causing a more severe recession.

In Europe, we have strong services and consumption, a tight labor market, but poor manufacturing. That is especially a negative for Europe because the continent is much more manufacturing-intensive and export driven compared to the US. We expect relative softness from European stocks, which had outperformed substantially from the end of September 2022 to May, particularly when the currency appreciation is taken into account.

A good chunk of that European economic weakness is related to China. The reopening bounce has faded, and youth unemployment has skyrocketed. China is going to need more policy support to revive their sagging economy.

In markets, this is a solid backdrop for balanced portfolios. We may be breaking out of the S&P 500’s year-long range; a lot of this comes down to overly pessimistic expectations, low positioning, a solid economy, and bond volatility stabilizing. Globally, there is plenty of breadth. International developed market equities have outperformed. The DAX Index is at an all-time high, the Nikkei is at a 30-year high, while emerging markets are the laggard because China has underwhelmed.

The S&P 500’s forward P/E has expanded recently – the market is by no means cheap. But there is plenty of room for US stocks to re-price higher beyond mega-cap tech. We see a broadening of the equity market rally.

The Federal Reserve is trying to convince the market to price out rate cuts, and the market now finally believes them. The risk-reward in duration is more balanced. The Fed is likely to skip in June, and this should weigh on bond volatility. Meanwhile, credit is priced for a gentle default cycle. At about 9% at the index level, high yield is attractive considering the last decade and beyond of low coupons. If we are wrong on our optimistic economic view, we think the better way to position is to be long duration rather than short high yield.

State of Banks, Real Estate, Private Credit, and Bank Disintermediation


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