Negative impact of monetary tightening increasingly visible
Risk reduction: in US from investment grade to government bonds
Financial markets in April showed a bright outlook, with a moderate level of volatility and investors keeping an eye on the ongoing inflation concerns and the central bank's monetary policy. Global equities continued their upward trend, building on the momentum from the previous month. The MSCI All Country World Index returned 1.4%, following a strong gain of 3.1% in March, resulting in a year-to-date return of 8.8%. Defensive equity markets performed particularly well in April, with the MSCI UK returning 3.6% and the MSCI Switzerland gaining 3.5%, making them the best-performing major markets, while China lagged with a negative return of 5%. This reflects disappointment over the lack of significant new government stimulus measures, along with ongoing geopolitical tensions. Fixed income markets experienced a state of relative tranquility, characterized by minimal fluctuations in 2- and 10-year yields of US Treasuries and German Bunds. Commodities ended the month also little changed.
The broadly positive mood in the equity markets reflected in part clearer evidence that the Federal Reserve is pausing its tightening cycle, after having raised interest rates by another 25 basis points last week (to a range of 5-5.25%). However, a pause does not mean the FED is getting ready to cut rates soon. In contrary, the current data alone is not sufficient to warrant a pause: the labor market remains robust, with the unemployment rate declining to a 69-year low of 3.4% and wage growth increasing to its highest level since March 2022. And although US consumer price inflation is moderating, a core rate of 5.6% it is still too high. The Fed will likely be content to sit on the sidelines and hold tight for a while. It will consider the delayed effects of the 500 bps of rate hikes that have already been implemented, the continuing reduction of its balance sheet, and the credit tightening caused by the ongoing stress in the banking system. In contrast, the ECB signaled it has more work to do, with lending standards tightening and demand for borrowing decreasing.
The pause is unlikely to lead to a broad-based market rally as it has been anticipated for some time, and market pricing should reflect that. Sentiment and positioning data suggest there is enough dry powder on the sidelines waiting to be invested again, and a decent pullback in the stock market may be seen as a buying opportunity even before the first rate cut. However, while the investor’s bias may prevent significant market downside, the growth and earnings environment for the upcoming months does, in our opinion, appear challenging. While the headwinds may not manifest in corporate profits in the short term they are likely to affect stock market valuations later in the year. Our cautious profit expectation is mostly due to tighter lending rules, restrictive monetary policy, and cautious yield curve signals.
The risk that the US government might not be able to fulfil its payment obligations in less than a month has sparked concerns across financial markets. Recurring standoffs over the debt limits in the past have been resolved before they could ripple out into markets. However, three-month Treasury-bills are trading at a premium in their yields due to an elevated default risk in case of a government shutdown. Equity investors have not reacted with the same degree of concern as first quarter earnings have been better than expected.
While April data showed economic activity remained resilient in the face of mounting headwinds, the closure of another US commercial bank at the end of April highlights that the impact of higher interest rates has still not been fully felt in the developed economies. We stick to our cautious positioning and think it is prudent to maintain an underweight allocation to equities, particularly within the US, given the higher probability of a hard landing. We feel that the narrow credit spreads understate the risk of increased default rates inside corporate America, thus we have lowered our allocation to US investment-grade corporate bonds in favor of US treasuries for the month of May.
Please find attached our last Asset Allocation Update for May.