Year-to-date, global equities have rallied 11.2% on the thesis that US inflation is inflecting lower, US growth is resilient to one of the sharpest US rate hike cycles in modern history, and that the Federal Reserve’s anticipated June pause could mark the peak in rates.
This week could turn out to be one of the keenest tests for the increasingly prevalent “soft landing” thesis. US May CPI is set for release on Tuesday, with the Federal Open Markets Committee decision on US interest rates due on Wednesday, and policy meetings for European and Japanese central bankers on Thursday and Friday, respectively.
And while we cannot rule out further equity gains if US consumer prices undershoot expectations of a 4.1% year-over-year (y/y) headline rate and 5.1% y/y core reading, we believe investors should stay cautiously positioned in equities relative to highly-rated fixed income:
US economic resilience looks set to fade in the second half of the year.
We expect US economic momentum to fade in the second half of the year, particularly as the lagged effects of higher interest rates bite on both consumers and businesses.
While the scale of this lagged effect is uncertain, regional banking crises, rising corporate bankruptcies, and higher credit-card delinquencies suggest pockets of vulnerability to higher borrowing costs.
US economic data already point to weakening economic activity with the ISM Manufacturing survey falling to 46.9 in May, the seventh consecutive month of contraction. And while the same measure for services indicated a modest expansion with a 50.3 reading, holding above the 50 threshold that would mark a contraction, details like the lowest service sector price index since March 2020 suggest potential pressures ahead.
The Fed may pause rate hikes, but not cease given jobs and price data.
Investors are increasingly aware that a pause in the hike cycle need not necessarily mean an end, as demonstrated by recent surprise interest rate increases by both the Australian and Canadian central banks.
While our base case is for a pause at Wednesday’s FOMC meeting (and markets are currently pricing a 30% chance of a hike), we see scope for the Committee and Fed Chair Jerome Powell to use the press conference to deliver a “hawkish pause” in light of jobs and inflation data.
Overall, we interpret mixed US labor data (above-consensus nonfarm payrolls, softer average hourly earnings, and a three-tenths pick up in the unemployment rate) as indicative of a still-too-tight jobs market. Equally, core inflation trends still remain well above the Fed’s target, with three-month and six-month annualized measures standing at 5.1% and 4.8%, respectively.
Uncertainty around the path for US rates is likely to stay high as a result, with the market outcome more dependent on Powell’s press conference, the FOMC’s Statement of Economic Projections, and the “dot plot,” before ruling out further hikes.
US and global equity market valuations leave little room for error.
Even in the event of a “Goldilocks” scenario where US inflation moderates, the Fed ends its hiking cycle, yet the US avoids a major slowdown, we conclude that global equity markets are unlikely to stage a strong rally.
Global earnings revision ratios and earnings momentum have decoupled from historical leading indicators like the ISM New Order component. Relative to high grade bonds, global stocks look expensive based on both an equity risk premium and a yield gap basis (the difference between MSCI AC World earning yield and the US 10-year Treasury yield). Last, technicals do not indicate a likely surge in sentiment to boost stocks (the AAII Bulls Bear sentiment measure hit its highest level since November 2021) nor are investors positioned for the wide range of potential economic and market outcomes (the VIX Index of implied US equity volatility recently fell to its lowest level in more than two years).
In conclusion, we do not expect this week’s heavy data and central bank calendar to prove the market’s “soft landing” thesis conclusively. Uncertainty around the economic and market outlook is likely to endure in the second half of the year, with potential for cross-asset volatility to rise on increased data-dependency and shifts in market leadership. Overall, we maintain a least preferred stance on global and US equities, and suggest investors seek quality income in high grade (government) and investment grade debt.
Main contributors - Solita Marcelli, Mark Haefele, Matthew Carter, Jason Draho, Jon Gordon
Content is a product of the Chief Investment Office (CIO).
Original report - Stay cautious on stocks amid “soft landing” scrutiny, 12 June 2023.