May 05, 2023
May 05, 2023
The inflation and recession duality
May 05, 2023
Global equities continued their positive trajectory in April, with the S&P 500 Index returning 1.6%1. In local currency terms, the MSCI Europe Index and MSCI Japan Index each returned 2.7%1. In contrast, the MSCI Emerging Markets (USD) fell 1.1%1 with the MSCI China Index being one of the top detractors for the month, returning -3.3%1 due to earnings downgrades and US-China tensions. The majority of S&P 500 companies reported better-than-expected first quarter earnings, leading to an upward revision in the earnings projections for the entire year. However, with only a handful of names driving majority gains, the sustainability of this rally comes into question. Bond yields were range bound across the month, although they remained volatile within the range, with US 10-Year yield between 3.3%2 and 3.6%2. Overall, the US 10-Year yield slightly fell from last month, ending the month at 3.4%2. The VIX index also remained range bound, falling to 17.03 by month end.
US headline inflation slowed for the ninth consecutive period to 5.0%4 in March 2023, coming in below market forecasts of 5.2%5 and the lowest since May 2021. The Federal Open Market Committee (FOMC) announced a rate hike of 25 basis points6 after its May meeting. This brings the target range to 5.25%6, the highest since 2007. However, the language seemed softer than last time with no indication of a further hike. The US jobs market is still tight, but cooling slowly, re-enforcing the prospect that the Federal Reserve may be done with further rate hikes for the time being. However, if inflation becomes de-anchored, they likely will be quick to hike again.
Meanwhile in Europe, the UK remains the only western European country with double-digit inflation at 10.1%7. Higher-than-expected core inflation and continued labour market tightness is forcing the Bank of England (BoE) to keep policy tight. Eurozone inflation was relatively better at 6.9%8, falling sharply as plunging energy prices continue to ease pressure on the cost of living. With inflation still very high, especially compared to the US and long-term targets, we expect more work from the European Central Bank (ECB) and BoE.
After the turmoil in the banking sector in recent weeks, credit spreads appear to have calmed and smaller bank risks seem to be fading. That said, tighter lending conditions are likely to linger. However, the surprising strength, acceleration and positive momentum from the first quarter is likely to make it difficult for the economy to decelerate enough to produce a continuous negative growth rate in the second quarter.
The overall effects of central bank tightening have yet to be fully felt, even though the risk of a recession in the short term appears to have diminished. This implies that despite the recent improvement in data, balanced portfolio diversification remains crucial in the face of significant volatility. Bearing this in mind, we made the following tactical changes in April:
Oil and Global Energy equities
We trimmed our exposure to energy equities by closing out our US energy equities exposure, as we see less upside for oil prices after recent rises, in turn leaving less upside for US energy which has a higher beta to oil prices.
MSCI China equities
We reduced the overweight to MSCI China equities as positive earnings revisions have stalled, despite the reopening impetus. Moreover, elevated risk premium due to continued US-China tensions weaken near-term conviction.
US small cap equities
We added an overweight to US small cap equities during April, as relative valuations compared to US large cap are at historically attractive levels. Furthermore, bearish consensus and an overreaction of US small caps to the recent banking instability, are also supportive factors.
EUR high yield
We closed our EUR high yield overweight as we expect intensifying refinancing and economic headwinds to tilt risks towards wider spreads over coming months. A lack of capital availability and higher fundraising costs are likely to disproportionately impact riskier firms.
Global asset-backed securities (ABS)
On closing our EUR high yield overweight, we allocated the proceeds to our existing Global ABS overweight to increase our exposure to high quality yield. We remain confident in the allocation given limited exposure to commercial real estate and our expectation that US mortgage credit performance is unlikely to come under substantial pressure, even in a recessionary scenario.
The index performance is provided for illustrative purposes only and is not meant to depict the performance of a specific investment. Past performance is no guarantee of future results. See Disclosure section for index definitions.