investment insights
Closing on the peak
Lombard Odier Private Bank
As higher interest rates trickle through into the economy, how is financial stress affecting the outlook?
While governments’ and central banks’ rapid action has done much to safeguard financial stability, inflation remains too elevated. And that’s why central banks have raised interest rates again despite turmoil in the banking sector.
Unless there’s more instability, the US economy’s strength argues for restrictive monetary policy by the Federal Reserve. Services inflation remains high and the job market too tight. And with financial stress, credit conditions are now also key for monetary policy. Commercial bank lending standards will be stricter, slowing consumption and private investment further – bringing rates close to a peak and leaving less work for the Fed.
Slower credit, trade, manufacturing and housing mean subdued growth and easing labour markets in the US, with some recessionary episodes later in the year.
Meanwhile, growth in the euro area has improved, and the European Central Bank remains focussed on curbing inflation, with additional hikes in the pipeline. But in the face of financial stress, the ECB will also look to preserve financial stability.
In China, rebounding activity hasn’t pushed inflation higher and we don’t see any signs of economic overheating. We expect growth to surpass authorities’ official target, and reach around 5.5% this year.
With financial stress and geopolitics feeding uncertainties, the global outlook looks challenging. And while central banks need to maintain pressure to tame inflation, we are approaching peak monetary policy in the US and Europe, with rate cuts a story for 2024.
Until recently, investors worried about inflation and recessions risks. Now, all eyes are on financial stability.
Markets have entered a new phase, where any fresh economic or financial weaknesses would intensify volatility. For this reason, we keep a balanced portfolio positioning.
In equities, we favour economies where growth could surprise positively – such as China, Japan and emerging markets – as well as value stocks, and defensive sectors such as healthcare. In bond markets, banking turmoil pushed investors to switch from expecting high peak rates, to rate cuts over just a few days. We continue to focus on quality, with overweight positions in US Treasuries and investment grade credit.
In currency markets, we expect the US dollar to depreciate against the euro and the Japanese yen. In contrast, the yen looks like a compelling haven.
Finally, we have raised cash, and will look to deploy it once the path of interest rates and financial stability is clearer.
Authorities’ emergency measures have restored some calm. But we cannot rule out other fragilities emerging after such a rapid rise in interest rates. This would of course pose new challenges for the global economy, while investment opportunities are shifting to reflect a more multipolar world. Right now, that is visible in the different stages of the economic and monetary policy cycles in the US, Europe and Asia.
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