Still a positive scenario for the financial markets, but beware of two risks
Global economic activity continues to show reasonable strength, confirming a low risk of recession in the short term. Furthermore, inflation seems destined to consolidate its path of progressive moderation in the coming months. Both the Fed and the ECB appear intent on reducing interest rates as soon as possible. In this scenario, it is difficult not to conclude that things are objectively going well. In any case, it is important to monitor possible risks on the horizon. Especially two: the first is that central banks today are perhaps too accommodating with respect to current inflationary risks with possible upward price surprises in the second half of the year. The other, in a more medium-term horizon, is linked to the very high levels of public debt and deficits reached in quite a few countrieswhich could lead to episodes of financial instability.
This scenario leads us to three conclusions, with implications for our investment decisions. First: in the short term the market “party” is destined to continue and, therefore, for the moment it makes sense to maintain sufficiently “constructive” portfolio positions. Second: inflation risks are still more on the upside than the downside and it is, therefore, advisable to continue to limit duration risk, avoiding in particular the long part of the curve. Third: we prefer to continue to minimize exposure to government bonds from countries with public debt and high deficits, favoring instead credit positions and, above all, looking for currencies that offer sustainable levels of carry and that are issued by countries with low inflation and sustainable from a fiscal point of view.
US economy heading for soft landing
Based on the information available so far for the first quarter of the year, let's see the United States is growing at slightly higher rates compared to their long-term potential. US consumer and business inflation expectations remain reasonably well anchored. The current improvement in the balance between aggregate supply and demand, combined with inflation expectations close to the Fed's target, lends credibility to a scenario of a soft landing of the economy and gradual price moderation. Eurozone macroeconomic activity also continues to show signs of recovery, with inflation expectations well anchored in the euro area.
While the central scenario for the global economy continues to point to growth in line with potential and inflation gradually declining, central banks may not be paying sufficient attention to the possibility that neutral rates today will be much higher than recorded in the period between the global financial crisis and the pandemic.
In turn, this relative complacency on the part of central banks about the degree of tightening of their monetary policies could lead to tighter financial conditions than necessary to control inflationary pressures in a lasting way.
In the medium term, the most unbalanced side of the global economy is not in private balance sheets, but in public ones, which at some point could lead to episodes of financial instability. The problem is not only the number of countries with very high public debt and structural deficits, but the lack of willingness of a large part of the global political class to assume the electoral costs that would predictably be associated with the implementation of ambitious programs of consolidation of the balance.
Beyond what has been said so far, the other elements of our core macro scenario remain unchanged: growth in emerging Asia continues to look good; data in China continues to surprise on the upside and supports our thesis that growth rates around 5% are perfectly achievable this year. Japan continues to move calmly in its monetary policy normalization process. The next step will probably be the reduction of purchases of public debt, which during the year could translate into a significant upward movement of the long part of the government curve.
Market view:
Equities: the core macro scenario is objectively positive and, for this reason, we believe that constructive equity exposure is still possible. In terms of style, we aim for balanced positions between value and growth and, at the same time, we believe that cyclical stocks, in an environment of relative economic strength, can do better than defensive stocks in the remainder of 2024. From a geographical perspective, we prefer European stocks to US stocks. We also like the small business segment in the US, which have a little tighter valuations in a segment that is not cheap at all. Finally, we believe some exposure to emerging Asian equities, including China, should also be considered, in the latter case due to signs of macro improvement and attractive valuations.
Government bonds: While we believe long-term rates in the US are now relatively close to fair value, we remain cautious on duration risk. In the case of the German curve, we believe that the current levels of medium and long-term rates are compatible with real rates that are too low and therefore we see clear upside risks in those parts of the curve. At the same time, it cannot be ruled out that the delicate budget situation currently characterizing several Eurozone countries could lead to episodes of widening of spreads. As for Japan, our forecast is that the 10-year bond yield will tend to rise significantly in 3-6 months, perhaps after the BOJ decides to reduce the pace of debt purchases.
Corporate bonds: We continue to favor corporate bonds because, in our central scenario, default rates are not expected to rise too much. However, given that spreads are already very tight, we continue to believe it makes sense to combine credit exposure with well-selected positions in emerging local currency government bonds.
Currencies: The ECB maintains a very dovish tone, which should lead to some weakness in the euro in the coming months. For this reason, we continue to view long positions in well-selected currencies very positively. Within developed countries, we maintain a positive view on currencies such as the Norwegian krone, the New Zealand dollar and the Australian dollar. In the emerging world, we continue to favor currencies of countries with good macro governance, high carry versus the euro and favorable economic growth prospects (Brazil, India, Mexico, Indonesia). In the particular case of the US dollar, at $1.07 we are only moderately long, considering the valuation and our doubts about the US budget situation, and because we believe that the growth differential between the US and Europe will narrow significantly as we move forward. of 2024.
*Chief Economist, Amchor IS
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