Investment Strategy Insights: Trust and the US Dollar

Stance: In the US, the winter’s white-hot labor market has cooled but remains too strong to be consistent with the Federal Reserve’s 2% inflation target or an immediate recession. Still, tighter lending standards combined with monetary policy lags support the likelihood of a recession in the second half. Continuing to affect the market, however, are higher long-term inflation expectations, as measured by the University of Michigan survey, and stronger-than-expected wage data, which have exacerbated concerns about inflation’s peak and its potential stickiness. Inflation is also a concern in Europe, where the European Central Bank (ECB) has raised its deposit rate to 3.25% and signaled a high likelihood of further rate hikes. In China, the reopening recovery has been uneven, with services showing strength while manufacturing remains weak and consumer borrowing is tepid. Industrial production was up just 5.6% year-over-year (y/y) in April, only slightly more than half the increase anticipated. Despite some choppiness, we still foresee a consumer-led reopening and policymakers providing support to cope with softness in manufacturing.

Outlook: Despite firmer domestic economic data and increasing conviction in China’s reopening, we are increasingly confident of a recession in the second half.

Risks: 1) Inflation falling faster than expected or the Fed looking through services inflation and pivoting earlier; 2) systemic issues in either Europe or the US; 3) more resilient economic fundamentals across Europe and the US.

Uncertainty over a debt ceiling deal and the ongoing banking crisis pushed bond market yields down and fueled eye-popping volatility. Fears of bank failures continue to haunt smaller institutions and seemed to be exacerbated by Treasury Secretary Janet Yellen’s comments to the press that more bank mergers (i.e., failures) could be forthcoming. While the debt ceiling was resolved at the 11th hour, banking problems persist, and for now the self-inflicted chaos looks set to continue.

Policy rate differentials and growth differentials remain the key currency drivers for the medium term. Forward-looking indicators and the ECB’s recent tone suggest it will stay hawkish for longer than the Fed, and the shrinking policy rate differential should support a stronger euro. Since tighter lending standards typically hit economic activity two or three quarters down the line, the combination of 15 months of monetary policy tightening by the Fed and tight US credit conditions are likely to trigger a US recession, with Europe perhaps three to six months behind. China’s reopening drove economic growth significantly higher in the first quarter, but the economy is now hitting some speed bumps and recovery has proved uneven. Nevertheless, we expect growth to stabilize at a higher level in the third quarter and support a widening of the developed market/emerging market (DM/EM) growth differential, although China’s growth surge will be less investment-led than in the past.

While a “US only” recession historically leads to a weaker US dollar, and as most measures suggest the dollar is still overvalued on a trade-weighted basis, we believe the dollar will weaken over the next 12 months. Cyclically, the US dollar is also overdue a correction. Reversing last year’s trend, we have noticed that weaker oil prices are affecting the terms of trade in favor of the euro and the Japanese yen, but the latter is facing uncertainty over the Bank of Japan’s desire to exit yield curve control, leaving the euro in the driving seat among the G3 currencies. Meanwhile, EM currencies have found a new lease on life, sparked by a favorable disinflation and growth mix

The resolution of the US debt ceiling should lead to a decline in rate volatility and a return to a focus on the “Fed peak.” As a result, our scores and weights remain unchanged. We expect a Fed pause for the remainder of 2023 as part of our “Classical” scenario (weighted at 55%). We see inflation moderating faster in EM than in DM and a widening EM/DM growth differential that supports EM generally and EM local currency debt in particular. Ultimately, markets are very risk-averse in pricing political uncertainty, creating opportunities for contrarian thinking. In EM, policy uncertainty is greater than usual and higher than it has been since 2020. Market inefficiency in pricing appropriate risk around EM elections makes it worthwhile for EM investors to travel to countries with elections beforehand. In Latin America, version 2 of the “pink tide” has been less radical than version 1, reflecting an antiestablishment tenor but not a shift to socialism. When leftist governments come into office, high-value industries are normally the first thing looked at, whether for more revenue or for more restrictive regulations. Overall, however, left-leaning leaders have been kept on a leash by the strength of the institutional framework.

Despite the prevailing view that “everyone is bearish,” to our eye the markets appear quite bullish, considering the narrowness of credit spreads, a razor-thin equity risk premium, and three rate cuts priced in for 2023. Our score is unchanged because we remain cautious. While the economy is likely to weaken and markets are pricing imminent rate cuts as a done deal, further hikes – while a harsh move for markets – are not out of the question. We expect the Fed to pause and wait for the data to come in before determining whether to cut rates (as widely presumed) or hike them. Meanwhile, wage pressures show no signs of abating, productivity is chronically underperforming, and super-core inflation appears to be reaccelerating, so we think it’s a big bet to assume credit tightening will fine-tune the economy to just the right degree. As the pendulum swings on regulation and supervision of midsize banks, their primary customers, small and medium-sized businesses, which have accounted for most job creation, will feel the brunt of the impact. Economic tightening is a slow, cumulative process and we expect US rates to settle higher for longer while the Fed’s balance sheet begins to shrink once again. China offers a partial offset, in our view, and its consumption-led recovery will help most emerging countries make headway even with less spillover benefits than in China’s prior investment-led recoveries.

First-quarter earnings have been better than expected, with companies surpassing expectations on their ability to pass through higher costs. Along with moderating inflation and an anticipated end to central bank hiking cycles, the MSCI All Country World Index is up 20% since October and 7.5% year to date. There is no shortage of concern in the markets, but worries about a slowdown in consumer spending have not yet materialized. Spending remains strong and companies in the consumer staples and discretionary categories are among those with the best recent results. Market volatility continues to present us with investment opportunities across the entire market, with long-term opportunities remaining in areas such as near-shoring, net-zero emissions, and automation. As always, we maintain balance in the portfolio across our stable and cyclical holdings.

We are keeping our score unchanged as geopolitics continues to weigh on financial markets and economies. Valuations, however, are very appealing and offer excellent long-term upside potential. In China, the order outlook at automation manufacturers is weakening, due in part to the high base and to economic uncertainty, with no clear change catalyst in the near term. Expect competition to remain intense at personal care companies and for inventory digestion to boost re-stocking demand for personal computing companies. In India, financial companies report robust credit growth with strong balance sheets and positive commentary, while many consumer discretionary companies have reported margin support from lower prices for commodities and energy. In Latin America, many Mexican companies reported in April, with strong results for many companies under our coverage in the staples, financials, materials, and real estate categories. Reports coming from most Brazilian companies should reflect the more challenging macroeconomic environment. Companies in Central and Eastern Europe are reporting generally better-than-expected results, but off a low base.

We improved our score slightly as the curve flattened by 2 basis points (bps), which is more than offset by the positive contribution from tighter credit spreads, which declined by 6 bps for BBB rated credits. Global credit forecasts remain positive on EM over DM. In DM, our model favors industrials, technology, and capital goods and dislikes financials, REITs, energy, and banking. In EM, the model likes technology, media, and telecom, as well as infrastructure and oil and gas. It dislikes pulp and paper, consumer goods, and real estate. Our global rates model forecasts lower yields globally and a flatter curve in Europe, the UK, and Oceania, with a slightly flatter curve in Japan but a steeper curve in the US and Canada. The rates view expressed in our G10 model portfolio is overweight global duration, with North America and Japan overweighted and Europe underweighted. Along the curve, we still position for flattening, with overweights in six-month, 10- year, and 20-year durations and underweights in two-year, five-year, and 30-year durations.