This week, three of the world’s most powerful central banks raised rates to new 14-year highs and signalled they are likely to hike at least once more and remain restrictive for a while. However, markets chose to look at the bright side – that the sharpest series of rate hikes in more than four decades is nearing its end. US stocks broke above key resistance and European stocks rose to a nine-month high, having recovered more than four-fifths of the losses since the end of 2021.
We are more sceptical about the outlook for risk assets, though; we now expect the Fed and ECB to raise policy rates to 5% and 3.0-3.25% respectively in H1 and maintain them near the peak for the rest of the year even as economic data deteriorates. Restrictive rates and wage gains are likely to impact equity valuations and erode corporate margins, leading to earnings estimate downgrades. This outlook confirms our SAFE asset allocation stance at the start of the year: staying overweight on higher grade bonds and other income assets at the expense of equities. Add to that crowded investor positioning, and we would continue to fade the rally in US and Euro area equities and look for opportunities to rebalance to bonds and stocks in Asia ex-Japan, where the outlook is brightening.
Of course, our latest review of the macro environment indicated several improvements since late 2022:
a) Headline inflation has peaked in major economies, enabling central banks to slow the pace of (and in some cases end) rate hikes; b) China and the Euro area economies are recovering, aided by policy stimulus and a plunge in gas prices (the IMF this week bumped up 2023 growth forecasts sharply); c) A weaker USD is easing global financial conditions and risk sentiment; d) Institutional investor positioning remains bearish on equities (although less so since Q3 last year); e) As a result of the above factors, risk assets are pricing in a goldilocks scenario of a shallow downturn in the US and Euro area, without severe dislocation to job markets and consumption as inflation gradually settles back towards central bank targets.
Nevertheless, we believe the scenario that markets are pricing in, extrapolating the above improvements, is too optimistic:
a) Global growth is set to slow this year as policy rates become restrictive, even as the dire outcome in Europe has faded; b) the US economy is slowing decisively (this week’s contractionary ISM Manufacturing and New Orders PMIs attest to that); c) Yet labour markets in the US and Europe remain tight (as seen in bigger-than-expected rise in US job openings, drop in initial jobless claims to near-record lows and Euro area jobless rate staying close to near-record lows); d) Core inflation, especially in services sector ex-housing, remains high in the US and continues to rise in Europe; e) China’s recovery is likely to add almost 0.5-1 percentage points to global inflation, challenging the disinflation narrative in the coming quarters; f) Corporate earnings are likely to slow as margins tighten, while earnings estimates have yet to be downgraded significantly; g) Expectations of an economic soft-landing and central bank policy pivots are contradictory – central banks are unlikely to cut rates if the economy and job markets don’t deteriorate sharply. Central banks are also unlikely to tolerate a significant easing of financial conditions (through higher stock markets and narrower HY spreads) before the inflation battle has been won; and h) several risk assets are showing one-sided investor positioning, raising the risk of a near-term reversal. These include Europe and Asia ex-Japan stocks, the EUR and gold.
Investment implications: On balance, we believe many risk assets have likely run ahead of fundamentals. While strong momentum points to near-term upside for US and Europe equities, we would look for opportunities to switch to Asian ex-Japan equities. We also see further downside for the USD and broadly stable US bond yields in the near term, which should support flows to Asia.
By Rajat Bhattacharya – Standard Chartered
