Sebastian Mullins, Head of Multi-Asset & Fixed Income Australia, at Schroders
Fed may cut rates up to three times before the end of the year
We remain positive on equities overall but continue to be concerned over stretched US equity valuations and extended market sentiment. We are becoming more confident about the US soft landing in the near-term. US growth is slowing but from strong to good, inflation is cooling and retail sales are holding up. This is enough reprieve for the US Federal Reserve (Fed) to cut rates, maybe up to three times, before the end of the year. This will relieve pressure on the pockets of the US economy that were reliant on floating rate financing, from microbusinesses to lower income consumers. Lending standards are already starting to ease. While the purchasing managers index from ISM shows activity slipping, response rates to this index continue to fall. Both the S&P Global US manufacturing and services PMI remain well above 50, with recent reports showing solid expansion in staffing levels and an increase in new orders. The S&P business outlook survey showed the strongest business confidence in over two years with increased investment plans. Despite slowing on the margin, the US economy remains resilient.
A Trump presidency could negatively impact big tech and tariffs on emerging markets
As the rate cutting cycle approaches, it is likely that sector rotation within the US will begin. Mega-cap companies like the Magnificent Seven have left the other 493 stocks in the S&P behind. However, with rate cuts on the horizon and low recession risk, the rest of the S&P 500 should start to play catch up. Adding to this theme is the increased likelihood of a victory for President Trump in the November election, which would likely benefit real economy businesses more than the tech companies, which Trump continually rails against. Unlike 2016, the market is front running a Trump presidency, which could provide a ‘buy the rumour sell the fact’ if he gains office in January 2025, when policy volatility could rear its head.
Activity is also improving in Europe and Asia. We have upgraded European equities given improved fundamentals, plus a better entry point after the shock France election announcement. We do however remain cautious on emerging markets given the likely tariffs coming from a potential Trump presidency.
Credit | NEUTRAL Investment Grade & High Yield
We continue to favour Australian and European corporate credit over the US due to relative valuations. While US corporate valuations are uninspiring, we do not predict spreads to widen given our view on the economy, therefore investors can continue to collect carry. Given most of the yield to maturity from corporate bonds is due to the price of the bonds below par, spreads could tighten further given the expected recovery on these are higher than in the past. Australian IG credit spreads are the most attractive on a relative basis (51st percentile).
While Australia is at a greater risk of falling into recession if the Reserve Bank of Australia (RBA) is forced to resume hike rates, the current spread is compensating somewhat for this outcome. Within the US, securitised credit remains cheaper than corporate credit, with spreads on government guaranteed mortgage-backed securities above investment grade corporate bonds.
While we have been positive on the front end of the US yield curve and believe the slowing of inflation has given room for the Fed to cut up to three times this year, into 2025 we believe US growth and a weakening fiscal position post the election could put pressure on the back end of the curve. In Australia, the RBA will likely be forced to raise rates this year. Any rate rise would increase the chance of a recession, with growth already weak.
Structurally we prefer to hold some exposure to inflation-linked securities, as a hedge against higher inflation. We continue to hold inflation-linked bonds in the US and Australia.
USD view downgraded as several rate cuts probable
We have downgraded our view on US dollar (USD) to neutral, given the increased likelihood of US rate cuts this year. This was offset by upgrading our negative view on the euro to neutral. Tactically we believe the USD can weaken as the Fed begins cutting rates and the EUR finds support as political risk in France subsides. We maintain a positive view on the Australian dollar given the RBA will likely be the most hawkish central bank, likely having to hike this year. We continue to favour emerging market currencies.
ENDS
