Tensions in the Middle East and the prospect of fewer rate cuts create a challenging market environment. Yet growth prospects remain robust says Dr. Claudio Wewel, FX strategist at J. Safra Sarasin Sustainable Asset Management, in the following analysis.
Consolidation on the back of geopolitics
The market environment has turned more challenging in April as markets have virtually priced out the possibility of the Fed delivering a first policy rate cut in June. The escalation of the conflict in the Middle East has additionally weighed on market sentiment and consequently bond and equity markets could not extend the gains made in March, but entered a consolidation mode. The global equity market dropped by more than 3% in April, driven by the US market. Europe held up relatively well, while the UK market even posted solid gains.
Bonds also trended somewhat lower as markets reassessed the Fed’s rate cut trajectory, which led to a rise in longer term Treasury yields. Credit spreads remained roughly at their March levels. Commodities posted the highest returns in April. Most notable is the continued outperformance of gold, which touched a new all-time high at $2’400/ounce, or a year-to-date performance of 11%, of which more than 3% were delivered in April alone. In our view, the superior gold performance predominantly reflects higher structural demand from emerging market central banks and increased physical purchases in China. Other parts of the commodity market also fared well, in particular copper, while oil remained flat.
Manufacturing rebound carries on
Given the rebound of PMIs in several developed economies and China, the global manufacturing cycle appears to have turned the corner. In the US, recession risks have fallen as both – growth and inflation continue to surprise to the upside, which brings us closer to a «no landing scenario». The resilience of the real economy will make it hard for the Fed to cut its policy rate as long as there is no clear return to the 2% inflation target. This also means that dollar strength is set to continue over coming months.
In the euro area, business cycle indicators suggest that the economy is growing again in the second quarter of this year. As of late, economic activity is also picking up in France and Germany, which have both been lagging over the past year. Most importantly, euro area inflation is coming back to target much more quickly than in the US, which likely warrants a first rate cut by the ECB in June.
Switzerland remains the only economy in developed markets where inflation is within its target range. In combination with a weak economic outlook, the SNB is expected to deliver a second rate cut in June, which also argues for a weaker Swiss franc in the near term.
In Japan, this year’s shunto – the annual Spring wage negotiations between Japanese labour unions and companies – delivered a strong wage increase and hinted at more rate hikes to come. But at last week’s meeting, the BoJ surprised markets with a less hawkish than expected forward guidance. Given the weakness of the Japanese yen, the probability that the BoJ will support its currency with FX intervention has clearly risen.
At 5.3% year-on-year, China’s GDP growth surprised to the upside in the first quarter, primarily driven by strong exports. We expect these dynamics to persist for the rest of the year. Yet weak price dynamics point at subdued local demand, which is underscored by a renewed increase in household savings and should weigh on corporate profits.
Rate expectations have risen, once again
Strong US macro data has led markets to price for a higher probability of a stronger and more resilient growth environment. Surprisingly, US financial conditions seem to be relatively loose despite the sharp increase in real rates. The latest CPI prints also put the continued progress on disinflation into question, which will impede the Fed’s ability to cut rates. The repricing of policy rate expectation has also affected the longer end of the interest rate curve, with the 10-year yield on US Treasuries rising to around 4.6%, the highest level in the last six months. Given that markets currently expect the Fed to deliver between one and two rate cuts, the policy rate will likely remain within restrictive territory until 2025.
Similar to the Fed, the BoE will likely not start cutting before the third quarter. Markets are somewhat more optimistic on the ECB’s rate cut trajectory. Yield curves have remained inverted in most developed markets. The fact that this constellation has persisted over the past two years is particularly noteworthy since inverted yield curves typically only last for a few months. In the near term, we think that the risk is tilted towards somewhat lower yields at the shorter end of the curve. Credit spreads remain significantly below their historic averages. Some spread widening is likely, but the low risk of a recession suggests that the rise should be limited.
Good start into the earnings season
Equities have performed well year-to-date, given that markets have virtually priced out the risk of a recession. Yet the persistence of elevated inflation and the escalation of geopolitical tensions in the Middle East have led to a moderate correction in April. So far, US earnings have proven solid in the current reporting season. But results could still change materially, given that roughly half of the reports is still outstanding.
Going forward, the cyclical strength should support equities, but current market valuations (as measured by price-earnings ratios) already reflect positive earnings expectations and make the market somewhat vulnerable to disappointments. European and UK equities look well-positioned to benefit from a rebound of the global manufacturing cycle. In particular, the UK should profit from its energy and materials sector, while a weaker pound sterling should lend further support. Similarly, European equities will likely profit on the back of their manufacturing edge, while it seems that Japanese equities no longer benefit from the weakness of the yen.
Tactical increase of equities
On the back of the recent escalation in the Middle East conflict and the recent inflation prints, stocks have corrected in the second half of April. Given the opportunity arising from the temporary weakness in financial markets, we have increased equities and reduced investment grade bonds. Overall, equities remain slightly overweight and bonds slightly underweight in our portfolios. The geopolitical situation has stabilised and growth prospects, along with the earnings outlook remain robust and hardly show signs of weakness.
The recent macro data are pointing to a broadening of the upward trend in equities. Hence our positioning remains ‘neutral’ with regard to regions and sectors. We still favour developed over emerging markets and put an emphasis on the quality of the invested companies.
The same applies to our positioning in bonds, where we continue to prefer medium-term maturities. The increase in interest rate differentials between various portfolio currencies mean that we are placing more emphasis on domestic bond markets. The majority of our allocation to alternative investments remains in catastrophe bonds, which continue to offer attractive yields.
