Too much complacency about a soft landing
In the first half of 2023, the US recession we expected did not materialise. The US economy has proven to be more resilient than expected to higher interest rates. Inflationary pressures have started to ease in many countries and corporate earnings have held up. But there remains a lot of risk ahead, and too much complacency about a soft-landing in the US. There are four main reasons why a recession did not materialize in the first half:
- Consumers were stronger than we expected as they drew down excess savings
- Fiscal stimulus led companies to invest in capital expenditure
- The transmission mechanism of higher interest rates is taking longer to impact economic growth
- The labour market has shown remarkable resilience
We still expect a US recession, albeit shallower and delayed until 2024. The recession will be driven by:
- The drag from monetary policy as the delayed impact of rate rises feeds through to debt servicing
- US consumers running out of excess savings
- Student debt payments, which have been on hold since March 2020, but are set to resume in October
- Diminishing corporate capital expenditure
In equity markets, we started the year conservatively given our macro expectations and also because multiples and margins were very high. What happened was unusual: an expansion in multiples despite real rates moving further into positive territory in a scenario where earnings contracted in the first six months of the year.
What we got wrong:
We missed out on an equities rally, which was driven by a surge in a group of technology-focused stocks, the so-called “Magnificent Seven”. However, the rally’s base was narrow and without those seven stocks, the market tells a different story. While the Nasdaq is up over 30%, more than 5% of its constituents are trading at new 52-week lows. This does not happen in a bull market. Market expectations for earnings per share growth of 12% in the S&P500 next year look high. This is why we are still prudent on equities for the rest of the year.
What we got right:
Our preference for Japanese and euro area equities in the first half worked well, as did our underweight view on small caps, which are more leveraged. More broadly, we put a lot of emphasis on avoiding accidents – and we were successful in that regard, especially in Q1. Moreover, we were right to be overweight investment grade US and euro area corporate bonds, and overweight emerging market corporate bonds.
Adjustment:
We have moved from neutral to underweight on the CHF as slowing inflation has reduced the need for aggressive action from the SNB, which may not want the franc to be too strong given weaker economic activity. We have moved from neutral to overweight on local-currency emerging market bonds.
Looking ahead…
Europe is flirting with recession, dragged down by weakness in its largest economy, Germany. In China, the housing market is looking worse than expected – though we do not see the current issues to be systemic.
We have three investment themes for the remainder of 2023:
- Treating – and trading – volatility as an asset class in its own right. Volatility is low but hawkish central banks, enduring problems in China and economic uncertainty risk it picking up. Various option strategies can be used to protect portfolios should this happen.
- There are signs “bond vigilantes” may be back, ready to impose discipline on policymakers, and to press them to keep inflation expectations under control by demanding higher government bond yields. In this context, US, euro area and Asia investment-grade corporate bonds offer enticing yields and should remain attractive so long as inflation is tamed and the economic downturn moderate.
- From globalisation to “friend-shoring”: Geopolitical tensions keep increasing, leading to a global reassessment of corporate supply chains. Moreover, the US and Europe are attracting companies through fiscal incentives. A period of “friend-shoring” is underway and should benefit debt and companies in the emerging markets that are gaining from this shift.