“Not only does God play dice, but… he sometimes throws them where they cannot be seen.”
— Stephen Hawking
Summary
Markets roared back to life in early May as credit spreads further narrowed, equity indices rallied, and S&P 500 Index volatility fell to its lowest level since before the pandemic.
These moves followed the release of softer US data and dovish comments from the Fed, with rates-sensitive growth stocks and retail investor favourites outperforming.
But the momentum did not last the whole month as rates started to rise again and the ‘soft landing’ narrative took a knock amid stronger US and European data and stickier inflation prints.
But any rate forecasts should be taken with a heavy a pinch of salt: elevated bond volatility and the seesawing of sentiment have been defining themes this year and last. There are too many potentially confounding factors to undergird a high conviction base case.
We have gradually extended duration (where we are underweight) and reduced credit risk (where we are overweight) in recent months and we expect this process to continue.
Biden’s embrace of ‘green’ tariffs reinforces America’s turn away from free and open trade and towards an active industrial policy. Favoured sectors are an obvious place to fish for opportunities, but mispricing of the risks around ‘reshoring’ are likely to create compelling discounts in markets deemed to be ‘in the firing line’ as well.
Markets bounced, but the rally has faded
After a choppy, challenging month in April, markets roared back to life in early May. Credit spreads further narrowed, equity indices rallied strongly, and S&P 500 Index volatility (as measured by the CBOE Volatility Index or VIX) fell to its lowest level since before the COVID pandemic, indicative of an increasingly bullish consensus in favour of US stocks. These moves followed the release of softer US payroll data and dovish comments from Fed Chair Powell at the May FOMC, both of which caused hawkish bets to recede and US rates to fall, particularly at the long(er)-end of the US sovereign curve. This positive trend continued through the middle of May, with markets further propelled forwards by the outsized gains generated by rates-sensitive ‘growth’ stocks and retail favourites like Google, Microsoft, and, latterly, NVIDIA, which shot up after releasing blowout Q1 earnings last week and is now almost as valuable as Apple! However, in the past 10 days some of the momentum has been lost, rates have started to rise again, and the goldilocks ‘soft landing’ narrative has taken a knock.
“In the past 10 days some of the momentum has been lost, rates have started to rise again, and the goldilocks ‘soft landing’ narrative has taken a knock.”
New data points to a possible recovery in US consumer confidence, despite core inflation still surprising to the upside, and, at the same time, there is evidence of an economic turnaround in the UK and continental Europe, where inflation is close to target and GDP growth appears to be accelerating. Indeed, conditions in the UK appear good enough that Prime Minister Rishi Sunak has decided to call a general election for the 4th of July (one that almost all polls suggest will result in an opposition landslide, but more on that next month). A better global economic environment may mean that US rates, at least, will have to remain ‘higher-for-longer’ to dampen aggregate demand for US goods and services and ensure that US core inflation falls below target in the medium-term. Investors are now fully pricing in just one rate cut in the US and two in the Eurozone (where rates are lower) before the end of the year, down from six cuts apiece in January; and, if the weakness of the latest US Treasury auction is repeated, rates are likely to move higher from here. Perhaps there really are limits to how much US debt the market is able to absorb…
Whither rates – and fixed income – from here?
Nevertheless, any US and European rate forecasts should be taken with a heavy a pinch of salt. For our part, we think that US rates have likely backed up more than is justified in recent months and that two or three cuts in the US, towards the back-end of the year, is reasonable as a base case. Meanwhile, we expect European rates to be cut more quickly (with the first such cut in June) and at least as aggressively. But we do not have a high degree of confidence in these assessments. Why? Elevated bond volatility and the seesawing of market sentiment – driven by mixed economic data releases, indeterminate central bank statements, the trajectories of wars in Ukraine and Gaza, and the push-and-pull of competing narratives about the stickiness of inflation in the US and beyond – has been the defining market theme this year and last. If six cuts can become one in just a few months, who can say for certain where rate expectations will be at the end of the year?
Many known unknowns (and countless unknown unknowns) could confound expectations before then. For example, there is the small matter of the US Presidential election, which is perhaps one of the most consequential for global markets in decades given the likely impact of a Trump victory on global security, economics, and trade; and, in the meantime, we anticipate a concerted effort by Russia to break through the frontlines in the Donbas and capture more territory around Kharkiv and Sumy in the North East of Ukraine over the summer. Whether this effort succeeds or not and the extent to which NATO is willing to commit resources to keep Ukraine in the fight if the scales move in Russia’s favour will surely impact European and global commodity markets and safe haven assets. And such risks may yet pull the rug out from under the market bulls… We have gradually increased duration and reduced credit risk in recent months, while remaining shorter duration and longer credit risk than global bond benchmarks. This has worked as spreads continued to narrow and rates have steadily risen (albeit on a non-linear path that allowed us to extend duration close to the peak in Q3 2023). Credit spreads have now hit tights that reflect only the most optimistic scenario for the global economy, despite a high degree of macroeconomic uncertainty, and we would look to taper our credit exposure further if equities did not look more expensive still! Rates, meanwhile, and as outlined above, may move a little higher in the short term (and perhaps stay there for some time). But we are convinced that peak rates are behind us and there will likely be meaningful asymmetric payoffs to extending duration further in the coming months. We do not feel the need to move quickly but move we likely will.
“We are convinced that peak rates are behind us and there will likely be meaningful asymmetric payoffs to extending duration further in the coming months.”
Biden embraces tariffs to go green
President Biden unveiled sweeping tariff hikes on Chinese electric vehicles (‘EVs’), solar panels, steel and other goods this week, in an effort to protect the equivalent US industries from cheaper Chinese products and to bolster flagging support from blue collar workers in battleground states ahead of the election in November. Tariffs will rise from 25% to 100% on EVs, from 25% to 50% on solar panels, and from 7.5% to 25% on various steel and aluminium products.
Most analysts expect the Administration’s use of ‘smart’ industrial policy to raise costs for US consumers (at least in the short-term) and to harm the fight against climate change by slowing the EV transition and by further reducing the scope for international collaboration on emissions reductions. But they underscore America’s tectonic shift away from free trade, notably but by no means exclusively in relation to China. For its part, China has responded to the tariff hikes fairly cautiously, with export controls on aviation equipment, technology, and software (nominally for national security reasons). Trump’s position, meanwhile, is that the tariffs are not broad enough given that they target (rather ‘unmanly’) green industries alone; and should he win the Presidency back in the autumn, Trump is likely to usher in higher tariffs and a much more profound shift in global economics towards protectionism. From an investment perspective, these policy changes reinforce the appeal of favoured sectors (such as AI and renewable tech/energy) and countries (such as Mexico and India). But we are cognisant that the ‘reshoring’ or ‘de-globalisation’ trend is now sufficiently well-understood by investors and that the market may periodically misprice its pace as a result, creating discounted opportunities in markets that are thought likely to be ‘in the firing line’. China’s stock market rally in recent months is a case in point.
“These policy changes reinforce the appeal of favoured sectors (such as AI and renewable tech/energy) and countries (such as Mexico and India).”
If you have any questions about the themes discussed in this article, please do not hesitate to get in contact with us: info@bedrockgroup.ch
Resilient global growth data mask divergent fortunes among major economies: the US and some emerging markets are growing strongly while most other developed markets are at a crawl. Still, global inflation is falling and multiple policy rate cuts are expected in the coming months. Upside inflation surprises cannot be ruled out, notably given the wars in Ukraine and Gaza. But there is a clear, if narrow, path to a global economic soft landing. That markets have fully priced in this optimistic outcome nonetheless suggests that risks are skewed to the downside. Bonds and gold are obvious places to take shelter, while pockets of value in equities can also be found.
In this article we explore the opportunity presented by US small-caps, overlooked in recent years by investors who have driven a powerful but ever-narrowing rally in US large-cap stocks instead.
In June's market update, we highlight the continued rally in Big Tech stocks, the prospects for rate cuts in the months ahead, and the impact of market-moving elections.
