investment insights
Riding summer storms in markets
Key takeaways
- Concerns over a weakening US labour market have compounded a pre-existing negative shift in investor sentiment. This has been intensified by extended investor positioning, low liquidity and elevated geopolitical risks
- We expect the Fed to cut interest rates at each of its remaining meetings this year, in September, November and December. The August jobs report will likely inform the magnitude of the September cut, whether it will be by 25 or 50 basis points
- Despite some softening in the labour market, we judge the US economy and consumer to be in relatively healthy shape, and see limited recession risks
- We keep portfolio and equity risk at strategic levels, with a preference for UK stocks. Equity markets could see some stabilisation in coming weeks but we expect elevated volatility to persist. The Swiss franc should remain supported by haven demand
Last week’s disappointing US labour market report sealed a change of sentiment in markets that had already started building over the summer. In the space of a few days, financial markets went from discounting an immaculate ‘soft landing’ scenario for the US economy to fearing a ‘hard landing’ and rising recession risks. The US 10-year Treasury yield fell sharply and was trading at 3.7% at the time of writing, while market expectations of Federal Reserve (Fed) interest cuts have soared to an expected 125-130 basis points (bps) of cumulative cuts by year-end. Market expectations of Fed cuts saw big swings earlier this year. From prior concerns around overheating of the US economy, we are now back in a scenario where recession risks are at the fore. Equity markets are, with some rare exceptions including China, undergoing bruising sessions. Japan’s Nikkei market has fallen more than 20% from its July highs.
US recession risks and Fed outlook
Market concerns have focused on signs of weakness in the US labour market that were evident in the July US employment or ‘non-farm payrolls’ report. The US economy added 114,000 non-farm jobs in July, versus 175,000 expected. Notably, the unemployment rate rose to 4.3%, versus an expected 4.1%. Risks for the Fed are certainly looking more skewed towards labour market weakness than towards persistent inflation at this point. Having kept rates on hold at its July meeting, we now expect it to get ahead of the curve in September. The Fed can do this either by starting its easing cycle with a 50-bps cut in September, essentially making up for July’s decision to hold, or cutting rates by 25 bps and announcing strong guidance on the path of future cuts. In this case we would expect policymakers’ projections of future moves to indicate successive rate cuts in the remainder of the year. The August non-farm payrolls report, which will be published before the Fed’s September meeting, is likely to be the determining factor of the precise path of rate cuts. This could either be cuts of 50 bps, 25 bps and 25bps in September, November and December respectively, or three sets of 25 bp cuts.
We would also stress that while labour market softness is a cause for concern, and a reason for Fed action, the overall picture including GDP data, income growth, the state of private sector balance sheets, and employment is still one of a healthy US economy. Monthly jobs data can be volatile, and extreme weather including a hurricane in Texas affected July’s figures. The rise in the unemployment rate is being driven by slower hiring rather than an increase in lay-offs, which remain stable at low levels, and much of the increase has been concentrated among higher earners. Meanwhile, weekly unemployment claims have risen but remain more or less in line with seasonal patterns. We expect the Fed to be reactive, and it has made important shifts in its messaging already. Assuming the Fed does get ahead of the curve in September and follow our expected policy rate path, this should suffice to keep recession risks at bay in our view. We currently assign a probability of 20% or less to a US recession.
Market and strategy outlook
Equity markets have responded to increased recession risks, while fixed income markets have now priced in more than five Fed fund rate cuts of 25 bps by year end, from fewer than three earlier last week. We believe the recent equity sell-off may be exaggerated by extreme investor positioning, thin liquidity over the summer, and geopolitical risks. We expect equity markets to see some stabilisation ahead of the next US labour market report and the September Fed meeting. We note that the marked recent correction in technology stocks has been centred around semiconductors, the part of the market which was most ‘overbought’, or where prices had previously moved up fastest. Share prices of technology hardware and software companies have held up better. Following the correction, we expect markets with large semiconductor exposures like Taiwan to stabilise over the coming weeks.
Nevertheless, geopolitical risks in the Middle East have increased after the assassination of Hamas political leader Ismail Haniyeh in Tehran. Concerns are centred around Israel and Iran ending up in a confrontation and that the region becomes involved in a wider-scale conflict that impacts several countries and includes the US. The US presidential election campaign should also prove a focal point of uncertainty for markets in coming weeks. Having been subdued for most of 2024, the VIX index of US equity market volatility has now soared above 50 at the time of writing, a daily move that, if sustained, would be its largest since October 2020. We expect volatility to persist in the coming months, as highlighted in our Ten Investment Convictions for the second half and our latest Investment Strategy Monthly.
In view of the current environment, we keep equities at strategic asset allocation levels for now. We expect high dividend-paying stocks, including those in the energy sector, and attractively valued regions to outperform. Among our most preferred regions, we highlight UK equities, which offer both an attractive valuation, and an improving growth outlook. In our new thematic equity framework, rethink investments, we expect the rethink longevity theme, focused on population ageing, to outperform. All six investment themes continue to have strong structural drivers and we remain convinced about their investment relevance. We regard the market setback as an opportunity to build exposure to these multi-year, high conviction themes.
In currencies, we expect the Swiss franc to remain strong, particularly against the euro. We also expect the Japanese yen to continue its path towards fair value over time, although we believe the recent sharp appreciation may slow, given that it has been boosted by a sharp unwinding of investor positions in the last few days that may not be repeated.
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