By H2O AM

Overview

Since the end of 2023, global growth has remained robust while becoming less dependent on the US economy: Europe has finally rebounded and the recovery of the global manufacturing sector has supported growth in emerging markets, which are also benefiting from high commodity prices. While aligned with this scenario of positive global growth, H2O AM’s teams were anticipating a slowdown in growth and inflation in the US, with a limited risk that this would lead to a prolonged recession. However, potentially bullish factors prompted us to assign a significant probability to a scenario of reaccelerating growth and a postponement of monetary easing measures.

This theme of “renewed momentum ” has ultimately prevailed to date, particularly up to the middle of this year. This resilience has been underpinned by a high level of public deficit in the USA (7% of GDP deficit despite an unsustainable public debt trajectory) combined with a powerful wealth creation effect linked to the high proportion of US household savings invested in equity markets. Private-sector financial assets are equivalent to six times US GDP, and over 40% of them are in equities.

Outlook

As we enter the second half of the year, we are maintaining the same scenario, focusing on a soft landing for the US economy, as it becomes increasingly clear that the factors hindering the disinflation process are fading. Indeed, certain components of the core-CPI (Consumer Price Index), such as housing prices,OER[1] and transportation services, are beginning to normalize, albeit with a lag. What’s more, the upturn in immigration observed since the end of the Covid crisis is having a two-stage effect on inflation: in the first phase, which has now passed, the increase in demand generated by this immigration has fuelled inflation; then, in the second phase, and here we are, this immigration is having the effect of easing the labour market and limiting the second-round effects on wages.

United States: core CPI

Source: H2O AM & Macrobond (May 2024) – Core CPI excludes volatile prices such as food and energy.

Inflation in the core services sector (excluding housing) is largely dependent on labor market conditions. In the wake of the Covid crisis, labor markets around the world have tightened significantly, depriving economies of the possibility of replacing local labor shortages with unused labor capacity from neighboring regions.

Since last year, this inflationary dynamic seems to have eased significantly, with the wage-related part of price pressure beginning to fall. This price/wage loop is crucial insofar as it shapes the ability of central banks to fully commit to a rate-cutting cycle as soon as their credibility is no longer an issue.

Number of open jobs per unemployed person

Source: H2O AM & Macrobond (April 2024)

From this point of view, the European Central Bank (ECB) is less constrained than the Federal Reserve (FED). In fact, in the eurozone, the risk of monetary policy error is lower, as inflation is mainly explained by supply constraints (disruption of production chains, procurement, transport costs) rather than demand factors, which in the US are due to the wealth effect and fiscal stimulus.

Today, the factors contributing to the economic slowdown in the USA are gaining in importance, reinforcing our confidence in our initial projection of a synchronized slowdown. Growth is likely to slow under the delayed effect of high rates, weighing more heavily on the more vulnerable segments of the economy, such as small businesses, households with low wealth and younger people. Default rates on consumer credit have begun to rise, particularly among young and low-income households, while bank credit growth has slowed sharply. In addition, small businesses are feeling the full impact of rate hikes, leading them to scale back their investment plans and reduce their hiring intentions.

Source: H2O AM (June 2024)

Building resilient portfolios

Although we are entering a phase where macroeconomic uncertainty should diminish, market volatility will remain a factor to watch. By way of analogy, macroeconomics could be compared to a stroller walking in a given direction, while markets could be compared to a dog running unpredictably at the end of a retractable leash.

During periods of strong macroeconomic variations, the market reacts to these fluctuations mainly in the same direction as the macroeconomy. Conversely, when economic conditions stabilize and the environment becomes more predictable, the market gains the freedom to move in different, even opposite directions, as behavioral traps and cognitive biases become preponderant. On the one hand, the walker slows down; on the other, the dog runs in all directions. This creates a paradox: asset trajectories can evolve in the opposite direction to macroeconomic trends. In essence, 2024 marks a break with the last three years, as this year increasingly reflects market considerations rather than macroeconomic influences.

The core of our management process remains macroeconomic analysis, and we are primarily interested in the pace of the walker. Consequently, in such environments, our aim is to build portfolios that are sufficiently robust to benefit from market volatility, rather than suffer from it.

This involves managing portfolios capable of navigating changes in market sentiment triggered by unforeseen divergences between expectations and macroeconomic reality. In practice, this approach requires the use of multi-scenario strategies to improve portfolio resilience over the investment horizon.

The bond market is a recent example of such opportunities. At the end of 2023, investor sentiment also favored a soft landing scenario, with little regard for a reacceleration in growth. Six months later, expectations have shifted to a “no landing” scenario, with only a small number of rate cuts expected this year. This change in sentiment has restored defensive potential to bonds, which should now offer protection during periods of heightened market tension.

While hedging strategies are adapting to this dynamic, the core performance driver of H2O portfolios remains stable, anchored in fundamentals. Emerging assets, despite recent volatility due to political changes, illustrate this stability by maintaining their importance in our strategic allocation. This interest in emerging markets persists as several parameters continue to align in favor of these assets, such as valuation, risk premium, positioning and exposure to prevailing economic trends. In fact, the alignment of these parameters has even improved in recent months, particularly with regard to valuation and the yield premium.

In this context, for example, the recent correction in the value of the MXN (Mexican Peso) is viewed favorably. While this currency has returned to last year’s price levels, our portfolios have only returned part of the premium accumulated since 2023, indicating renewed potential returns with a healthier market positioning. The key to capturing value from these long-term themes is to stay invested in positions, adjust exposure during periods of stress, and build portfolios that can withstand volatility and mitigate downturns.

Published in Paris / London, July 12, 2024

Warning

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[1] OER (Owners’ Equivalent Rent): index that measures an “Equivalent rent for owners”.