New video — CIO Monthly: Inflections diverge (3:21)
Global CIO Mark Haefele on how investors should position as some parts of the market inflect earlier than others.

Thought of the day

What happened?

US equities declined and US Treasury yields rose on Friday after the US personal consumption expenditures (PCE) price index increased by more than expected.

Headline PCE inflation increased by 0.6% month-over-month in January, with the core measure rising by a similar amount. On a year-over-year basis, headline PCE rose by 5.4% in January—up from 5.3% in December. The core measure climbed by 4.7% (4.6% in December), more than the expected 4.3%. Personal consumer spending, adjusted for inflation, went up by 1.1% in January, the biggest month-over-month increase since March 2021.

The S&P 500 fell 1.05% on Friday. The decline was broad-based, led by the interest-rate-sensitive IT and consumer discretionary sectors. The tech-heavy Nasdaq dropped 1.7%.

Yields rose on concerns that sticky inflation and the strength of the US economy mean the Federal Reserve may have to raise rates further and keep them higher for longer. Yields on 10-year US Treasuries rose by 7 basis points to 3.95%, and two-year yields increased by 12bps to 4.83%, the highest level since 2007. Market expectations for the terminal fed funds rate implied by futures markets increased by a further 4bps to 5.395% in August, while the rate implied for December rose to 5.32%.

What do we expect?

The jury is still out on whether the US economy is headed for a soft or hard landing. Signs of resilient consumer spending suggest it is holding up well against the headwinds from higher interest rates. But equally, the stickiness in US inflation in January and a still-tight labor market suggest that the Federal Reserve will need to increase rates further, perhaps substantially, in order to bring inflation back to target.

Caught between these divergent potential outcomes, equity markets have been left trading well above October’s lows while also lacking the conviction to move materially higher.

In our Year Ahead 2023, we said that this would be a year of inflections, in which economic growth would first slow before reaccelerating around the middle of the year. At a global level, we think this view remains intact, but the latest data suggest it is happening at different times in different regions.

China and Europe’s economies are inflecting sooner than expected. By contrast, the resilience of the US economy is perhaps raising the risk of a later, deeper recession there, resulting in a more prolonged period of uncertainty.

These divergences mean we think investors should take a more regionally selective approach to their risk decisions, rather than making blanket “risk-on” or “risk-off” calls. Our positioning reflects this. We like select relative value opportunities that should help investors position for inflections across the global markets, but also reduce downside risks.

How do we invest?

Tactically, we think the current environment means investors should ensure they diversify beyond the US and growth stocks:

First, faster inflection points in Europe and China affirm our view that emerging mar­ket equities as well as select parts of the European market, including Germany, will perform better than US equities.

Second, inflation and interest rate uncertainty means we continue to believe value stocks―including the global energy sector―will outperform growth stocks.

Third, considering the downside risks to the US economy, we continue to advocate maintaining some defensive exposure, although among defensive sectors we now see greater opportunity in consumer staples than in healthcare.

Elsewhere, given elevated yields, we see a variety of opportunities across the fixed income spectrum, including in high grade, investment grade, and emerging market bonds. However, we remain cautious on high yield corporate credit.

We expect broad commodity indexes to move higher given constrained supply and strong demand. Commodities should benefit from China’s reopening, and we think the asset class is also a good hedge against the risk of more persistent inflation.

Lastly, we think less correlated hedge fund strategies can play an important role in portfolios as we navigate correlated mar­kets still driven by expectations for central bank policy.