Weekly house view | Pentagon Leaks
The International Monetary Fund’s (IMF) latest update to its World Economic Outlook contained no surprises. While the IMF stressed the risks to global growth from painful disinflation and tighter monetary policy, its top economist was sure that "it's not 2008". Indeed, markets last week cut back their expectations for Federal Reserve rate cuts. Focusing on sticky core inflation data for March and some signs that stress in US banking may be easing (for now), markets instead saw another, final rate hike from the Fed at the start of May.
The easing in banking stress could be seen in the reduction in banks’ borrowing from Fed facilities for the third consecutive week. Crucially, a majority of Fed officials seems to support another 25bp rate hike in May, barring a much sharper tightening in credit conditions than we’ve seen so far. The decision will come down to whether more emphasis is placed on solid, but lagging, real economic data, or deteriorating leading indicators, such as tightening credit conditions and signs of a rise in jobless claims. Our baseline post-SVB case has been for the Fed to pause on rate hikes, but if we do see a 25 bps rate increase in early May, we believe it will be the last in this cycle since we see a US recession in H2. Despite this risk of recession, we also believe it is unlikely the Fed will cut rates this year, since we believe core inflation will remain above its target. Together with elevated valuations, the removal of Fed support and the recession risk explain our cautious stance on US equities. In Europe, European Central Bank (ECB) officials continue to push for higher rates. Policy hawks refuse to rule out a 50bp hike next month, although we think a 25bp hike in May, followed by a hike of the same magnitude in June, is more likely. Equities’ positive performance continues to defy fundamentals as we enter the Q1 earnings season. But last week did see the Stoxx Europe 600 outperform the S&P 500, as it has year to date—in line with our preference. Big US banks, especially JP Morgan, released impressive Q1 results, but earnings reports this week from smaller US regional banks will come under particular scrutiny for signs that size matters when it comes to US banking. We are in a world of winner takes it all, leading us to underweight global small caps. Overall, we expect Q1 corporate earnings to show resilient top-line revenues. We could see more downgrades on earnings and margins, but past revisions have lowered the bar for surprises.
The Pentagon intelligence leaks suggest that the US is resigned to months-long stalemate in the war in Ukraine. French president Emmanuel Macron’s comments on the need for European strategic autonomy regarding China were poorly received, while Beijing retaliated against US trade restrictions by launching an investigation into US chipmaker Micron, which does 16% of its business in China. Germany shut its last three nuclear plants on Saturday—leaving questions dangling over precarious energy supplies in Germany and Europe at large. Given a tight supply-demand equation, we are positive on oil.