This challenge is evident from widespread calls a year ago for a U.S. recession that failed to materialize, recurrent bouts of concerns over “higher for longer” rates, and the growth resilience of emerging market (“EM”) economies despite a wobbly China. And even now that many pandemic and war-related dislocations have largely normalized, the cycle keeps surprising. The prevalent market view entering 2024 was predicated on steady disinflation and somewhat slower growth, a combination that would open space for major central banks to cut interest rates.
This “soft landing” narrative is coming under pressure, however, particularly in the U.S. where stubborn price pressures are forcing investors to rethink the start of rate cuts to a later date. Instead of a slowdown, meanwhile, promising signs of a turnaround in global manufacturing and exports are becoming more generalized. A path forward for the business cycle, and its implications for the risk rally, took center stage in the latest Global Strategy Meeting (“GSM”).
Soft landing off track?
How much more can bond yields rise until global stocks come under pressure? And could the world be heading towards a risk-off environment like October’s when fears over “higher for longer” rates dominated? Those were the top questions on the GSM agenda in April, which gained added urgency after the big runup that pushed most major stock indices to record levels. Prices for long-term Treasuries, by contrast, retraced more than half of their gains since the October lows. The starting point for the conversation lies with the U.S. macro backdrop, which keeps setting the tone for global markets.
Recent developments keep challenging the macro normalization story – of easing inflation and rate cuts – that boosted risky assets over the past five months. First, the U.S. economy remains resilient, leading to further upward revisions to growth estimates – up by one percentage point to 2.2% since January.1 Second, the disinflation path is becoming trickier after a string of bad inflation surprises, with the surge in commodities compounding concerns over price pressures. The result has been a scramble to postpone the start of rate cuts and higher volatility. Participants agreed that markets were too quick to claim victory over inflation. The rethinking of Federal Reserve (the “Fed”) expectations – and resulting dollar appreciation – is already causing EM central banks to be more cautious. Portfolio managers acknowledged that conditions turned more challenging; still, there was a case for equity exposure as long as growth remained strong, particularly in areas more leveraged to the synchronized cyclical upswing (see Figure 1).
They also flagged the cushion provided by the big shift in rates pricing which, unlike earlier in 2024, means markets now are positioned to be more conservative than the Fed’s guidance. Indeed, current consensus sees fewer rate cuts than the Fed in 2024 and pricing for terminal rates – running close to 4.0% – is well above the Fed’s 2.6% median projection.
The unusual business cycle
The discussion about the U.S. macro backdrop – and the large swings in expectations for growth, rates and other variables – revealed the unusual nature of the post-pandemic business cycle. Meaningful monetary tightening hardly restrained activity, for example, frustrating recurrent calls for a U.S. recession. Recent signs of stickiness aside, inflation eased materially without requiring a growth slump and higher unemployment. The reopening in China was meant to provide a powerful boost to global activity; when China’s recovery fizzled, growth in other emerging economies continued to surprise to the upside and is still holding up well. Labor markets in most major economies remain historically tight, even in Europe which keeps stagnating. Analysts pointed out that understanding the contours of the business cycle and where it may be heading is critical for asset allocation decisions and returns.
Recent market action seems consistent with a shift towards a late-cycle environment, including the jump in commodities, higher break-evens, and outperformance of cyclicals over defensives (see Figure 2). Markets still expect Fed cuts this year at a time when global manufacturing PMIs (including U.S. surveys) are improving – a highly unusual combination. Looking at historical parallels for guidance, analysts called attention to the mid-90s, another period of a long productivity-led expansion and job growth. Against this backdrop, the Fed achieved a soft landing after hiking rates from 3 to 6% in 1994-95; inflation was contained, too. One consideration for a repeat could be AI-linked productivity gains, which would allow growth to stay strong alongside inflation relief – a constructive outcome for global stocks.
The world should keep moving towards an “overheat” or late cycle regime if productivity gains fail to materialize, and trade frictions lead to a more muted supply response from EM, or both. Within this context, it is important to keep monitoring inflation figures; additional upside surprises could exacerbate “higher for longer” concerns by challenging rate easing expectations.
DISCLAIMER
The information provided herein is for educational and informational purposes only, and neither The Rohatyn Group nor any of its affiliates (together, “TRG”) is offering any product or service hereby. The information provided herein is not a recommendation, offer, or solicitation of an offer to buy or sell any security, commodity, or derivative, nor is it a recommendation to adopt any investment strategy or otherwise to be construed as investment advice. Any projections, market outlooks, investment outlooks or estimates included herein are forward-looking statements, are based upon certain assumptions, and should not be construed as an indication that certain circumstances or events will actually occur. Other circumstances or events that were not anticipated or considered may occur and may lead to materially different outcomes.
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Exposure to emerging markets generally entails greater risks and higher volatility than exposure to well-developed markets, including significant legal, economic and political risks. The prices of emerging market exchange rates, securities and other assets are often highly volatile and movements in such prices are influenced by, among other things, interest rates, changing market supply and demand, external market forces (particularly in relation to major trading partners), trade, fiscal and monetary programs, policies of governments and international political and economic events and policies. All investments entail risks, including possible loss of principal. Past performance is not necessarily indicative of future performance. The information provided herein is neither tax nor legal advice. You must consult with your own tax and legal advisors regarding your particular circumstances.
