Friday Investors Club podcast: The Fed gets a break (9:14)
Good news for the Fed, and trouble for the dollar, as CIO’s Teck, Wayne, and Jon discuss.

Thought of the day

As we entered 2023, the broad consensus was for the US economy to slow, infla­tion to fall, and China’s growth to accelerate. Six months on, the US economy has proven surprisingly resilient, headline inflation has fallen steadily while core inflation has been slower to decline, and China’s post-COVID recovery has disappointed.

Meanwhile, most expectations, including our own, were for broad stock market indexes to fall this year as earnings growth decelerated. Yet the S&P 500 has enjoyed the second-best first half in the last 20 years, powered by a robust US economy, a little inflation-driven nominal earnings growth, and a lot of optimism about a handful of companies associated with artificial intelligence.

In our latest monthly letter, we examine why all this has happened, whether a US recession, normalization in inflation, and China’s recovery are just postponed or outright canceled, and what it all means for the investment outlook.

In short, US data has undoubtedly been encouraging, and the Federal Reserve’s likelihood of staging a soft landing improves with every data point demonstrating resilient growth and falling inflation. That said, even though this is a better macro backdrop than we expected at the start of the year, we maintain our preference for high-quality bonds over equities, for three main reasons: First, the good macro news is already priced into the S&P 500, in our view, setting the bar higher for the rest of the year. Second, in the second half we expect an environment where inflation continues to fall, but US growth also slows, potentially close to zero. That situation is good for bonds, but generally not equities. Third, the uncertain scale of the lagged effect of prior interest rate hikes means that both recession and a Federal Reserve (Fed) policy error remain potential risks. Therefore, in our global strategy we prefer to spend our risk budget in fixed income and currencies rather than overweight broad US markets.

Meanwhile, in China, we expect the recent loss of momentum to prompt an eas­ier monetary policy and targeted fiscal measures designed to support growth.

Putting all this together, we see several ways for investors to position:

First, fixed income is our most preferred asset class. We like high-quality bonds, given attractive yields and their potential to act as a portfolio hedge against the risk of a US recession and Fed policy error. Among riskier parts of the asset class, we prefer emerging market bonds.

Second, within equities, we keep a selective approach. We focus on laggards that have underperformed during this year’s rally, including emerging market equities, and global consumer staples and industrial stocks. In addition, we think equal-weighted US indexes could continue to grind higher if data remains consistent with a soft landing. That said, the risk-return trade-off for market-cap-weighted US indexes is currently less appealing, in our view, given that the high weighting of a few technology stocks increases both aggregate valuations and idiosyncratic risks.

Third, we position for further US dollar weakness. Slowing US inflation—the headline consumer price index rose 3% in June, its smallest y/y increase since March 2021—has prompted a depreciation of the dollar, which fell to an eight-year low against the Swiss franc this week. We recommend that investors position for further dollar weakness over our forecast horizon. We retain our preference for the Japanese yen, and upgrade the euro to most preferred. We see EURUSD rising to 1.18 by June 2024. A weaker dollar should also support gold prices, and we continue to like the yellow metal as a diversifier and a hedge within portfolios.

Read more in our monthly letter, “Into the second half.”