Since the start of the year, we have maintained a view that inflation will cool and U.S. growth will moderate to a trend-like pace over the course of 2024. 

Despite some choppiness, the data tell us that this scenario is playing out as expected. Still, the market has swung from excessive optimism over the extent of rate cuts early in the year, to April’s concern that inflation might reaccelerate. 

With manufacturing surveys softening and business confidence muted, markets may begin to over-discount a sharper slowdown. Nevertheless, we continue to believe that the pace of economic growth is moderating, and inflation is cooling sufficiently to allow the Federal Reserve (Fed) to begin easing before the end of the year.

This environment supports a risk-on tilt in portfolios with overweights to equity and credit and underweights to duration and cash.

We expect U.S. growth to be close to trend at about 2.0% by the fourth quarter. Inflation, meanwhile, is falling more slowly than initially forecast. We expect inflation of around 3% at year end, eventually returning to the Fed’s 2% target by mid-2025.

Outside the U.S., the European economy is expanding once again, activity in China is stabilizing, and the global goods cycle is showing more signs of life. As U.S. growth moderates while other regions improve, global growth looks set to be well-supported and more broadly based. 

There are two key risks to our core view: stickier inflation or an excessive slowdown in activity. Despite the modest uptick in inflation early in 1Q24, recent measures show a cooler trend, and resets in one-off items, such as auto insurance, have likely run their course. On the activity front, economic growth remains underpinned by resilient labor markets.

For the economy to rebalance and inflation to cool further, a moderation in growth is necessary. Still, we are alert to the risk that slowing data gets disproportionately extrapolated. Such an event could offer attractive entry points to risk assets; thus we maintain some capacity to add on dips and extend our risk positioning.

Equities came through the first quarter earnings season smoothly. Despite cautious forward guidance, earnings themselves were strong enough to drive upgrades to forecasts. Our base case of trend-like nominal growth should support earnings growth of nearly 11% this year, but we do not anticipate the large jumps in investor or corporate confidence generally associated with an earlier cycle economy.

Our cycle indicators for the U.S. economy are evenly split between mid- and late-cycle. Historically such phases are associated with total returns in the low double-digits for U.S. stocks. We see limited potential for valuation expansion but feel confident that earnings growth can drive returns. We view large-cap tech earnings as resilient and see scope for an upside in cyclical earnings as the goods cycle evolves and inventories are restocked. 

The European economy, by contrast, appears to be earlier in its cycle. Several large countries, notably Germany, suffered mild recessions and are now rebounding. Given that European policy rates are set to fall faster than U.S. rates, and that improving Chinese economic activity should boost trade, we see scope for a modest recovery in Europe in 2H24. And while unemployment in Europe is low, the level of hours worked suggests a looser jobs market than headline data imply.

Regional growth and policy differentials, plus improvements in parts of the goods market, present relative value and stock selection opportunities across equity markets. Regionally, we continue to favor the U.S. and have recently rotated our most preferred cyclical region from Japan to Europe. Australia and emerging markets (EM) are less preferred, but within EM economies opportunities are starting to appear as the outlook in China brightens. In sectors, we favor communication services, tech, industrials, financials, and energy, with staples and materials being our least preferred.

Slower but positive nominal growth also provides a good environment for credit, and we have a positive tilt to both U.S. high yield (HY) and investment grade (IG) credit across our portfolios. We are mindful of refinancing needs that will build over the next 18 months. However, evidence from the primary market suggests robust demand and key credit metrics such as leverage and coverage ratios remain broadly healthy. From the borrowers’ side, refinancings are hardly a surprise and in a period of decent growth can be well managed. 

We expect the Fed to begin to ease rates before the end of the year. But while a cutting cycle is — on average — supportive for duration, historical performance is skewed by cutting cycles that result from recessions. Since we expect the Fed to embark on a modest run of mid-cycle cuts totaling around 75bps by mid-2025, and see only a limited risk of recession, we are underweight duration. Negative carry and the elevated level of rates volatility relative to other assets further reinforce an underweight stance to duration.

Differences in the pace and extent of cutting cycles around the globe create opportunities for relative value positions across both sovereign bonds and currencies. Despite some scope for near-term turbulence, our most preferred bond markets are peripheral Europe (Italy) where growth is recovering; we also see opportunity in the UK, where rate cuts in 2H24 seem likely. Our least preferred market is Japan, where we expect three further hikes in the next 12 months. In currencies, we favor carry and countries where we believe growth remains robust (USD) as well as cyclical exposure in Europe (SEK and NOK).

Although in the last quarter investors have pared their expectations for the pace of rate cuts, the major central banks globally remain on a cutting path. As policy rates decline, the attractive carry in cash today will quickly diminish and reinvestment risk will become acute. Thus, we treat cash as a funding source and remain fully invested.

At a portfolio level, positive correlation between stocks and bonds continues to be a challenge. Still, differences in the business cycle and the policy pathway across regions are creating tradeable variations in most assets and enabling further diversification within asset classes. As inflation cools and cutting cycles progress, we expect interest rate volatility to normalize and stock-bond correlation to decline modestly. A positive correlation backdrop, however, will remain a headwind for asset allocators going forward.

In sum, even as markets have overpriced various tail scenarios over the year so far, we believe that a gradual cooling of nominal growth is the central path forward. This calls for a pro-risk tilt, but also an acknowledgment that markets remain prone to over-reactions to data in both directions, requiring the discipline to trade around this volatility while remaining cognizant of the headwind from a positive stock/bond correlation.

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