The combined US unemployment and inflation picture suggests the Federal Reserve (Fed) will take monetary policy easing slowly. Two more 25 basis point (bp) cuts are expected this year. Progress towards a neutral stance probably needs inflation to decline a bit more and the labour market to ease a little more but things look pretty much on track. Beneath the hood, it looks good for markets. Corporates and consumers are in good shape. This remains a good environment for equities to potentially deliver capital growth and bonds to deliver stable income. And, you never know, there could even be upside surprises if we consider potential global scenarios for 2025, even if the current news flow is awful.
Slowly, slowly, softly, softly
Some have criticised the Fed for cutting rates by 50bp on 18 September. This is unfair and the Fed never indicated it would continue to ease by 50bp moves. The reality is that real short-term interest rates are quite high and potentially restrictive, and the economy is on track for a soft landing. The moving three-month average of payroll numbers suggests a year-on-year growth rate of employment of around 1.2%. This is reasonable but it is below what has tended to be the growth rate of jobs in the US outside of recessionary periods. The soft-landing scenario remains largely unchallenged.
Buyers again?
The retreat in bond prices might draw some buying into the market. The view is that the Fed will cut two more times this year so the Fed Funds Rate will end up at 4.5%. Given the core consumer price inflation rate came in at 3.3% in September, this leaves real short rates still firmly in positive territory. It remains a supportive environment for fixed income. For this year, global aggregate bond total returns might end up at around 3.0% with the profile being a negative first quarter (Q1), a flat Q2 and then an above trend return in Q3. For next year, it seems reasonable to set expectations at a similar or slightly higher level, with more to be gained from the credit markets given where spreads remain today.
Valuations rich in bond markets
The macro backdrop is supportive for fixed income even if there are risks from reflationary policies should Donald Trump win the election in November. Broadly, however, there are concerns about valuation. Rates curves are priced for a soft landing so bets on the direction of rates are either going to be non-consensus or tactical responses to short-term moves. On the credit side, spreads are narrow across all ratings buckets and currencies. Credit is towards the expensive end of its relative valuation versus a swap benchmark, and this is more pronounced in the US. The implication is credit’s excess return is somewhat limited (the carry) while there is asymmetric risk in terms of potential spread movements (i.e. there is more room for spreads to widen than narrow).
Also read: An Eventful Quarter. Fixed Income Perspectives
But yields and income attractive
However, from an all-in yield perspective, credit remains attractive as yields are still well above their pre-tightening levels. Interest rates are coming down, so the relative value of credit against cash is improving. Moreover, the fundamentals are solid for credit, demand is strong and, despite increased issuance this year, technical trends in the market are also positive. As with rates, there is likely to be a buy-on-weakness backdrop to demand for credit in fixed income markets, unless the fundamental backdrop changes. Any risk-off related to concerns about the geopolitical situation is likely to be followed by buying.
Soft landing favours equities
Under the central scenario equities offer better prospects for returns in 2025. Lower rates should sustain stronger trends in consumer and business spending while the structural themes of artificial intelligence and the net zero transition will underpin enterprise spend. The consensus view is that Trump would be positive for equities in the US, but Kamala Harris would only be mildly negative given her ambitions to raise corporate taxes would be thwarted by Congress.
Current earnings forecasts for stocks are strong. For the S&P 500 the consensus is for 14% growth over the next year and 25% for the Nasdaq Composite universe. A 14% growth in S&P 500 earnings, with the current multiple unchanged, would mean an index level of 6,100-6,200 could move into sight. There is also optimism around the outlook for small cap stocks with the consensus forecast for the Russell 2000 at 73% growth. Lower interest rates are helpful to smaller companies that are more reliant on bank financing and a broadening of spending in the economy. It was interesting that the correction in technology stocks at the beginning of the summer coincided with a strong rally in small caps, just as the market started to more aggressively price in Fed rate cuts. I also note that bank lending growth has started to pick up modestly after being flat for a year or more.
Earnings and politics key to the bull market continuing
Equity returns should outpace bond returns going forward on the assumption the soft landing does not become harder. The upcoming earnings season will be useful in setting those expectations as we approach 2025. If China’s stimulus is real and effective then global growth prospects will, at the margin, improve. A pick-up in the manufacturing cycle will be to the benefit of industrial companies and could allow some expansion of multiples in stocks in the automation, transportation, and construction sectors.
(Performance data/data sources: LSEG Workspace DataStream, Bloomberg, AXA IM, as of 10 October 2024, unless otherwise stated). Past performance should not be seen as a guide to future returns.
