Markets got over the near-term consolidation, as both bottom-up and top-down elements were helpful: from a micro level, the Q1 earnings season was supportive on both sides of the Atlantic, following a stronger-than-expected global economy at the start of the year. Signs that manufacturing is coming out of recession implies that the next leg could broaden earnings, beyond the US and the tech sector. From a macro point of view, we note that US news flow is now at odds with Europe and China: weaker-than-expected economic data in the US is compensated by positive surprises in the latter regions. The good news is that the hawkish repricing regarding Fed rate cuts has likely run its course. Finally, most recent inflation data, from the decline in the price of oil to April consumer price releases, has confirmed global disinflation trends. Stagflation may represent a risk scenario, but at the current juncture, interest rates have peaked and growth remains resilient, representing a favourable mix for our overweight stance on equities and our long duration positioning.
Stay in May
As expected, the month of April witnessed a consolidation following the strong performances registered in the previous two quarters. As a result, our composite sentiment indicator, based on a comprehensive set of market factors, technical data and investor surveys, has retreated after sending warning signs by hitting the “euphoria” level mid-March.
We note that, historically, stocks bottom in May and rally through August during US election years. Hence, “Stay in May”, June, July and August could be the right tactic before the election cycle warms up in earnest this autumn. Looking forward, we are again more comfortable looking at fundamental drivers.
The European activity cycle has turned a corner
Our more constructive view on European equities has been supported by the bottoming out in GDP data: growth reached 0.3% during the first quarter in the eurozone, while quasi-stagnation was expected. This pick-up in activity from quasi-stagnation should represent a support for equity valuations in the region and help performances to broaden further. Forward-looking indicators undoubtedly point in that direction.
In addition, the ECB has confirmed its intention to start removing monetary restriction on 6 June, being more dependent on improving (i.e. lower) inflation than on the Federal Reserve.
Digging into detail, Europe should register faster and more sustainable inflation deceleration than the US. Barring any shocks, our forecasts show that headline inflation in the eurozone may hit 2.0% towards the end of Q3, before slightly picking up and then spending most of 2025 just below the ECB target inflation rate of 2.0%. Core inflation in the region is expected to converge gradually towards 2.0% by H1 2025. To sum up, headline and core CPI at 2.5 % yoy today and moving below 2% in 2025 represent a sufficient condition for the ECB to start cutting in June.
Over the same 18-month horizon, we expect headline and core CPI in the US to stay above 3.0% this year, before hitting the central bank’s target in H1 2025. Clearly, these dynamics allow the ECB to cut interest rates earlier than the Fed.
The upcoming central bank rate cuts are an element which should cap long-term bond yields, motivating our long duration stance. Of note, it is also the first time in the 25-year history of the ECB that the reference rate will be cut due to improving disinflation and not faltering activity.
US economic data surprises to the downside – this is good news
Economic growth in the US has consistently surprised to the upside in the past 18 months, leading to consensus adjusting estimates upwards. As a result – and contrary to the relatively gloomy situation in Europe where the situation cannot really disappoint from a low starting point – the bar for the US economy in beating expectations has risen accordingly.
While growth remains overall resilient in the US, it would therefore be ambitious to expect an acceleration from here. In the past few weeks, several economic data releases have come in below expectations i.e. negative economic surprises.
There is good news to these downside surprises: market expectations regarding Fed rate cuts have likely run their course. The more hawkish market expectations for the Fed since the start of this year have come to an end, which corresponds to the peak in US 10-year Treasury bond yields at 4.70% at the end of April. Interestingly, the recent drivers of long-term yields have been both breakeven and yields, reflecting expectations for future inflation and growth.
Buy sovereign bonds and equities in this environment
We were reassured by recent central bank meetings and think that the upcoming central bank rate cuts in Europe are an additional element which should act as a support while capping long-term bond yields. As a result, we continue to stay long duration via European and US sovereign bonds.
In the US, 10-year bond yields fell from 5.0% in mid-October to 3.8% at the end of 2023, and rose back to 4.7% in April. We have reached the attractive entry point we were looking for and have therefore increased our duration in this region too.
Conversely, we recently reduced our exposure on Credit to neutral (Investment Grade, High Yield and Emerging Market Debt). This way, we booked some handsome profits on this long-standing conviction in a context of tight credit spreads. While we do not expect a material rise in spreads in the foreseeable future, there is little room for improvement either. We prefer taking the duration risk via sovereigns.
Regarding equities, we further increase our view from slight overweight to an overweight stance. We are keeping a cyclical bias in our allocation, and are therefore adding to Japanese and European equities, while somewhat reducing exposure to the US: among the major investment regions, the latter has the lowest sensitivity to an increase in global activity indicators, such as the Global Purchasing Manager Index.
Further increase allocation towards overweight equities
Equity: We are further increasing our view from slight overweight to an overweight stance. The recent activity indicators and upcoming rate cuts might further support markets.
Bonds: We were reassured by recent central bank meetings and think that the upcoming rate cuts are an additional element which should act as a support while capping long-term bond yields. It is the first time in the 25-year history of the ECB that the reference rate might not be cut due to faltering activity but improving disinflation.
Currencies: Commodity currencies could regain their appeal as the global manufacturing cycle picks up. We have reduced our long position on the Japanese yen as the BoJ appears overly careful.
We are raising developed markets exposure ex-US to slightly overweight
We continue to add some beta and cyclicity to the portfolio to benefit from a broadening of the favourable environment: lower inflation than expected and higher growth than expected. In Europe in particular, economic surprises are now positive, leading to improving sentiment and flows. Therefore, we are upgrading eurozone equities further, from neutral to slightly positive, adding small caps and banks to the portfolio.
Valuations are attractive in UK markets, with a potential for multiples expansion, while the Bank of England should start cutting rates this summer, following the ECB.
Exiting the multi-decade long deflation plus corporate governance reforms bearing fruit should more than counterbalance a less dovish Bank of Japan.
Regarding the US, the Q1 earnings season has been strong and the re-pricing of monetary expectations has likely run its course. The next leg could be earnings broadening, beyond the US and the tech sector, leading us to downgrade the region from overweight to slightly overweight.
No change in global equity grades; Upgrading real estate in Europe
Last month, we made a portfolio adjustment by downgrading the healthcare sector to neutral. This decision was based on a top-down view, considering the strength of the US economy and its potential headwind for defensive sectors like healthcare.
Regionally, we upgraded the real estate sector in Europe. However, we would avoid investing in offices and shopping centres, even if they offer deep value. We have a preference for logistics, student houses, third-age housing and residential. Technically speaking, we note that the relative strength is building a constructive sequence.
Prefer Carry to Spreads
We were reassured by recent central bank meetings and think that the upcoming central bank rate cuts are an additional element which should act as a support while capping long-term bond yields.
It is the first time in the 25-year history of the ECB that the reference rate might not be cut due to faltering activity but improving disinflation.
EMU Core: Upcoming cuts and easing inflation should be a support for the asset class.
EMU Non-Core: The shift in ECB policy might act as a support.
Euro IG: We recently reduced our exposure from overweight to neutral. This way, we booked some handsome profits on this long-standing conviction in a context of tight credit.
Euro HY: High yield spreads are tight while tightening credit conditions act as a headwind. Stabilising rating drift but defaults on the rise.
US Gov: US yields fell from 5.0% in mid-October to 3.8% at the end of 2023, and rose back to 4.7% in April. We have reached the attractive entry point we were looking for.
US IG: Short-term returns could be impacted by a consolidation following sharp spread tightening, longer-term attractive carry.
US HY: Some caution on US HY as the tightening of spreads means that the buffer for rising defaults has decreased.
EM Government Debt: Continued disinflation and emerging central banks’ easing firepower are supportive, while highest regional real yield level offers carry. However, spreads have tightened significantly already. In addition to hard currency exposures, a strong US dollar represents an additional risk for local currency bonds.
EM Corporate: Highest regional real yield levels offering carry. Spreads and yields are above historical average. “Dovish” emerging central banks should be supportive.
Buy commodity currencies as the global manufacturing cycle picks up
EUR: The EUR is currently supported by the bottoming out in activity but faces more rapid monetary easing than in the US.
USD: Markets have adjusted Fed rate cut expectations backwards, which represents a support for the greenback.
JPY: We have reduced our long position on the Japanese yen as the BoJ appears overly careful.
AUD/CAD/NOK: Commodity currencies could regain their appeal as the global manufacturing cycle picks up.
