Monetary Policy
Stocks should continue to rally in the near term, but investors should prepare to turn more defensive towards the end of the year in advance of a recession in 2024.
The Fed and ECB talked a good game as they redoubled their commitments to returning core inflation to 2% p.a. at Jackson Hole. However, their outmoded inflation-fighting playbooks do not address supply tightness in commodity and energy markets, which keeps inflation risk elevated. The proposed expansion of the BRICS states seeks to capitalize on these trends, and supports efforts to weaken the centrality of the USD in global trade. We remain long commodity exposure via ETFs to retain exposure to energy and metals producers and refiners.
In this report, we assess the best opportunities in inflation-linked bonds in the major developed economies, based on trends in growth, inflation and the stance of monetary policies in each country. We conclude that the environment is turning more challenging for European inflation-linked bond performance versus nominal government bonds, while the opposite is true in Japan. In the US, US TIPS breakevens have likely peaked, particularly at the short end.
Investors should prepare for an equity market pullback this fall, prefer Treasuries over stocks, and US defensives over cyclicals. A pullback could also morph into another bear market given that monetary policy is tight, policy uncertainty will spike, global growth is slowing, and geopolitical risks are still high.
The next six-to-nine months hold a crucial test of whether the equity market will ratify the soft landing and the Biden administration or not. If so, then markets will rally on policy continuity and likely gridlock. If not, then markets will struggle until the election is over and again in 2025-26.
Time is running out on the Bank of England’s tightening cycle. UK economic growth is flirting with recession, unemployment is rising, house prices are contracting and inflation is decelerating. Markets are overestimating the eventual bottom in UK inflation, and thus are also underestimating how much the Bank of England will eventually cut rates in the next easing cycle, which could begin as soon as H1/2024. The backdrop is turning increasingly positive for Gilts on a medium-term basis, while the overbought pound is due for a breather.
Some thoughts on this week’s bear-steepening of the Treasury curve and this morning’s employment report.
The Supreme Court is a generator of certainty rather than uncertainty for US markets. In the event of a constitutional crisis, a court intervention will likely reduce volatility.
The US is not out of the woods when it comes to inflation, which means that it is too early to conclude that the Fed can stop raising rates. Any further increase in inflation risk would prompt us to turn more cautious on stocks.
Stay cautious on Chinese stocks. Equity investors should use any rebound in onshore stock prices to downgrade A-shares from overweight to neutral within global and EM equity portfolios. Remain underweight Chinese investable/offshore stocks. Onshore bond yields will drop to all-time lows. Continue receiving 10-year swap rates. The currency will continue depreciating versus the US dollar in the coming months.