By Karsten Junius, chief economist at J. Safra Sarasin Sustainable Asset Management
The financial market turbulences this week have highlighted that macro risks are shifting from inflation to growth, carry trades are vulnerable to sharp reversals in late cycle environments and expectations regarding the additional earnings potential from artificial intelligence (AI) have their limits as well.
Downside risks to economic growth have increased as the global manufacturing sector has slowed again. However, spill-overs to the service sector are more moderate than in previous cycles. We are also convinced that markets have interpreted the latest US labour market report far too negatively. Consequently, we do not expect an immediate US recession or an emergency rate cut by the Fed before the September meeting. That said, we now forecast three Fed rate cuts by 25bp this year instead of just one. This is less than market expectations of more than 100bp, for which we would need clearer signals that the US economy is growing significantly below trend or falling into a recession. Economic data in the euro area have disappointed as well, supporting our expectations for three rate cuts by the ECB and the BoE, and one cut by the SNB in the second half of this year.
Consequently, we forecast bond yields to fall further over the next 6 to 12 months. We continue to favour intermediate maturities and have a neutral assessment on credit, both for Investment Grade and High Yield for now. In the FX space, we expect the yen to push higher, despite the sharp rally, as the yield gap to other currencies gets narrower. On the equity side, we retain our defensive stance. We note that companies provided a rather downbeat view on the US consumer in their Q2 reporting. We would thus reiterate our cautious stance, given the persistent uncertainty around the economic cycle as various indicators imply that the current slowdown has room to run.
Financial markets received a wake-up call as markets corrected due to concerns about an imminent US recession, the unwinding of yen carry trades and a more negative view about the earnings potential of US equities in a global slowdown. Geopolitical tensions in the Middle East contributed to the general risk-off sentiment. While there is an element of truth in all of these points, the market has been overly pessimistic. Hence, we consider the partial rebound in risk assets that followed as justified.
It is true that macro data have disappointed over the previous weeks. This weakness, however, was mainly concentrated in the manufacturing sector as purchasing manager indices (PMI) in the US, China and Europe have shown. Spill-overs to other sectors are limited as the increase of the ISM index for the US services sector in particular showed. Markets also put too much weight on the weaker US labour market report last Friday. First, it might be biased due to adverse effects of hurricane Beryl. Second, there was an overly strong focus on the so-called ‘Sahm rule’ that was triggered by the increase in the unemployment rate. The indicator signals that the US economy is in recession when the three-month average of the unemployment rate rises by at least 0.50 percentage points within a year.
The US labour market report led some market participants to conclude that the Fed is far behind the curve and needed to lower policy rates quickly and significantly. Together with the BoJ’s rate hike, this would imply a narrowing US interest rate advantage, making foreign-currency-funded carry trades less attractive. The unwinding of yen-funded carry trades triggered the initial sell-off. While we agree that US-Japanese interest rate differentials should shrink further, leading to a stronger yen in the coming quarters, we do not believe that the Fed is behind the curve. Additionally, the BoJ’s vice president indicated that further interest rate hikes would be unlikely this year as long as markets are unstable.
Some market participants are moderating their expectations regarding the earnings potential of AI and some companies are reporting fading consumer demand in the US and China, yet the Q2 earnings season in the US was solid. In our equity strategy section, we will explain why we prefer more defensive sectors.
Overall, we believe that markets and central banks will focus less on the still elevated inflation rates and more on the labour market and deteriorating economic growth perspectives. In this environment, we expect three rate cuts by the Fed (previously one) and confirm our expectation for three more rate cuts by the ECB this year. Additionally, we have revised our forecasts for 2024 as follows: Euro area and Japan inflation both up to 2.5% from 2.4%, UK GDP up to 0.8% from 0.7% and GDP growth in China down to 4.8% from 5.1%. For 2025, we have lowered our inflation forecasts for the US to 2.6% from 2.7%, for Switzerland to 1.0% from 1.1% and increased it for Japan to 2.1% from 2.0%. We also increased our 2025 growth forecast for Japan from 1.2% to 1.3%.
