By Chris Iggo, Chief Investment Officer, Core Investments, AXA Investment Managers
The lower inflation gets, the easier it is for rogue numbers to upset the narrative. We are now in that phase and recent US inflation reports illustrate this. The big picture, however, is that inflation is lower and is consistent with a soft landing scenario. In the US, growth has not slowed by as much as expected and inflation is a little sticky. That’s okay though. The risk of rates moving higher is limited. The chances of rates not being cut by as much as they could be is being well flagged (even if sell-side forecasts are more aggressive). Investors like stable credit yields and the implied carry that brings to fixed income portfolios. And if economic growth is better, then the equity return foundations are also better. The macro environment remains supportive for investment-grade credit, high-beta credit and growth equities.
The only way is up
This is a bull market characterised by strong momentum and rising valuations. It is most obvious in US growth equities, high yield and high-beta credit, and crypto-related assets. The macro narrative supporting this market is that a US soft landing is the most likely scenario relative to a hard landing or no landing at all. It is all about the US. Europe is struggling to avoid stagflation and China is fighting a renewed round of deflation. Global market sentiment and behaviour is driven by what is happening in the US. With an election looming, that will continue to be the case for the rest of 2024.
Soft landing
The current state of the economy means the Fed does not want, or need, to cut rates aggressively. Some sell-side forecasts are looking for more cuts than currently priced in – and this is especially the case for forecasts of the European Central Bank’s (ECB) policy rate – which points them towards a “harder landing” scenario. (This might just reflect the conditioning of expectations of monetary policy responses that were forged in the era of unconventional monetary policy). Current pricing puts a 60% chance of a rate cut in June and a total of 100 basis points’ (bp) worth of reductions in the Fed Funds Rate by year-end.
Also read: Optimism on Rates Cuts May Be Overdone
Hard landing
A hard landing scenario would imply much weaker growth data in the months ahead, disinflation, a more pronounced rise in the unemployment rate and a decline in corporate profits. Rates would be cut more aggressively in this scenario and financial markets would respond in a typical ‘recessionary’ way with risk premiums rising on equities and credit, and bond yield curves steepening rapidly. There is a risk of this scenario, but even the more challenged parts of the world have avoided a hard recession – Europe and the UK have flat growth profiles and China is set to make 5% growth again this year. The chances of a hard landing in the US need either a shock or a meaningful change in the monetary policy outlook.
No landing
A no-landing scenario is where growth does not slow enough to allow spare capacity to emerge, or residual inflationary pressures to ease. The stickiness in service sector inflation together with growth close to trend might tilt the Fed towards keeping rates higher for longer. Some market commentators have publicly argued that the Fed will not cut interest rates at all this year. While a hike in rates is a very low probability outcome, financial conditions could tighten if rate expectations reflect no change. A no-landing scenario which avoids ending in higher inflation and more tightening would be nothing short of an economic miracle and depends entirely on a US productivity surge. There is a lot of hope that artificial intelligence (AI) can boost productivity, but it is probably too early for it to bend the laws of economics that much.
Reset and carry
The soft landing core scenario is turning out to be bullish for markets. Rates are expected to be cut, globally (except in Japan), and if a recession is avoided then risk assets can continue to perform. What we observe now is that the current scenario is very positive for credit. Valuations adjusted to higher rates in 2022-2023 and return expectations are now positive. Investment-grade credit is fundamentally sound and provides an income stream that can be used to match liabilities more effectively than when yields were very low. Carry is an attractive return in a soft landing scenario and total returns will be boosted when rate cuts come.
Nothing lasts forever
No scenario will last for ever. A no-landing would eventually become a hard landing because financial conditions would be tighter for longer. A soft landing will come to an end because of concerns over exuberance, renewed leverage growth, profit dilution or fiscal problems. Hard landings don’t last because central banks lower rates, asset classes become cheap and business models are reset. But for now, the soft landing backdrop looks set to be in place until at least the US election later this year. There is maybe also a psychological reinforcement when it comes to the political outlook – the economy and markets are good which means no need to rock the boat and re-elect Donald Trump, which is good for markets.
Rates bulls want a hard landing because that will boost returns from duration and yield curve steepening strategies. They are not getting it now. I would argue that if rates bulls are eventually right and central banks ease aggressively, they will be doing so because not only will inflation be back at target, but growth will be weak and that will bring stresses for corporate balance sheets and cashflows. In other words, what is good for rates is not likely to be good for credit and equities. The data might eventually provide that long-duration and short-risk opportunity. But not for the now.
(Performance data/data sources: Refinitiv DataStream, Bloomberg, as of 14 March 2024, unless otherwise stated). Past performance should not be seen as a guide to future returns.
