Key macro and market views

US

US inflation has moved past the peak, and the US Federal Reserve will likely pause rate hikes

US inflation is now below 5%. This gives the Fed room to pause and hold rates in restrictive territory in 2023 before cutting in 2024.

Macro views

From peak of 9.1% in middle of last year, US inflation is now less than 5% and trending lower across the board. While energy inflation is negative and food inflation is moderating from an elevated level, core inflation is moderating slowly.

This move past the peak of inflation means the Fed can pause its policy of aggressive interest rate increases, which started in March 2022. However, with inflation level still so elevated and the job market so strong, we don’t expect any rate cut whatsoever this year (despite what the market has priced in). Rather, we believe the Fed will pause its monetary policy tightening cycle and hold rates at this level for the rest of year. It’s only in 2024 that, in our view, rate cuts are more plausible.

Market views

The chart shows that the yield of a short-term US Treasury bill is roughly the same as the earnings yield of the main US equity index – the S&P 500. This is an extreme example, but demonstrates the point that we believe the risk-reward for equities is poor compared to high-quality bonds. The combination of slower economic growth and inflation in the US, together with our view that the Fed will pause its cycle of rate increases, is supportive of US Treasuries and investment grade bonds.

We remain cautious on US high yield bonds as we expect spreads (the difference in yield compared to government bonds) to widen as a result of stricter lending standards, weakening economic conditions and higher default rates.

The positive performance of the US equity market this year has been dominated by a small number of mega-cap growth stocks (such as the ‘household names’ in the tech sector), unlike the more broad-based Eurozone equity performance. The market is currently pricing in up to four rate cuts by the Fed this year, which would support US growth stocks. However, we think this is too optimistic and it’s more likely that the Fed will hold rates where they are for the rest of the year, putting these stocks at risk.

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EUROPE

Eurozone/UK inflation and rates lag the US

In the US, inflation peaked in June 2022 but only in October 2022 in the Eurozone/UK, where it is still very high. The ongoing policy tightening from the European Central Bank and the Bank of England is weighing on inflation, with several indicators pointing to a slow easing of price pressures.

Macro views

Unlike the US, where both headline and core inflation have marked a clear peak, the Eurozone and UK still have some way to go in their battle to curb upward price pressures. Unlike the sometimes-mixed messages from the Fed, European Central Bank President Christine Lagarde has been clear in her messaging: the central bank still has ground to raise interest rates, and the inflation outlook is anything but certain.

In the UK, inflation remains comparatively elevated, and the Bank of England has recently adjusted its projection for inflation to slow to 5.1% by year-end, instead of its previous forecast of 3.9%. This means that we’re likely to see at least a couple of extra rate increases from both the European Central Bank and the Bank of England, but we believe they will follow the Fed’s lead and, perhaps more tentatively, pause in the next few months.

Market views

The outperformance of Eurozone equities since the end of 2022 has been supported by cheap valuations and surprising economic resilience this year. However, economic surprises are now rolling over and we believe Eurozone earnings expectations still look too optimistic.

In Europe, cyclical sectors and the broader market tend to underperform defensive sectors during economic downturns and volatility spikes throughout history. Therefore, more defensive sectors (such as health care and consumer staples) and countries (such as the UK and Switzerland) look attractive to us and can provide a more stable and diversified exposure to the broader European equity market (which, of course, also includes the Eurozone).

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Emerging Markets

China’s reopening and stimulus looks set to continue

In the absence of upward price pressures in China, the People’s Bank of China will likely keep interest rates low or even reduce them. This, accompanied by the continued re-opening, means that activity on services and consumer spending are likely to expand.

Macro views

A recent batch of economic data in China raised some concerns the economic rebound may be losing steam. However, we think the economy has room to normalise further. With weak inflation, China will likely continue to support its economy with low interest rates, which should support growth across the Asia-Pacific region.

China seems to face a lack of domestic confidence after three years of strict lockdown, but this will likely come back and the record-high domestic tourism data we got recently supports this. In addition, the economic normalisation through a return of consumer confidence takes time.

This has been the case in Japan, which lifted most of its restrictions in 2022 but has only been visible in the data in the first quarter of 2023 as economic growth rose and beat expectations.

Market views

We believe the recovering growth in Asia-Pacific including Japan offers prospects of a sustained earnings-led recovery. Looking at valuations, the data suggests sticking with Asia-Pacific including Japan equities and reallocate away from relatively more expensive US market. Asia-Pacific is a region that’s highly geared to China’s reopening and stimulus story.

What’s more, we believe Japanese equities are attractive from a valuation point of view, supported by resilient corporate profitability, improving economic growth, loose monetary policy and better corporate governance following structural reforms. Japan’s story is both domestic, as its economy is continuing to reopen and recover, and linked to the wider trends across Asia-Pacific including China’s reopening.

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Information correct as at 25 May 2023

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