As we start the second quarter, three factors can potentially boost economic performance in the coming months. The first is the resilience of the US economy, which has surprised many market participants. The second is that market observers expected a US recession sometime this year–but the risk appears to have receded. If these factors stay true, it will likely lead to a third dynamic: a slower-than-expected rate cut by the Federal Reserve. Â
Additional growth drivers in the US, such as the labour market, still appear healthy, and an improved risk outlook could lead companies and consumers to make more robust spending and investment decisions. Additionally, the policy rate has likely peaked. However, the Fed could counter the economy’s strength by cutting rates fewer times than had previously been expected: the first rate cut could now be in June or July, with potentially only one additional cut this year.
Disinflation remains intact
This shift in rate cut expectations follows slightly higher-than-expected consumer and producer price data in recent months.
Despite this, we believe the disinflation story remains intact. Core services prices have been especially high, suggesting that while progress toward the Fed’s 2% inflation target will likely continue, it could be a bumpy road.
The Fed had already shown signs of caution, and higher-than-expected price data have validated its patient approach. While recent strong inflation readings may delay rate cuts, we don’t expect the Fed to keep the short-term risk-free rate higher than the economy’s nominal growth rate for long. But for now, the current data suggest a delayed and cautious cutting cycle.
Risk environment
Resilient growth, disinflation and the start of a rate-cutting cycle establish a favourable environment for risk-taking–yet this positive tailwind is offset by valuations that are not compelling. The positive macro backdrop is likely to prevail, so a positive exposure to fixed income should be favoured–but stretching for yield probably should not be. Given the macro backdrop, we believe risk should be kept contained. Volatility that leads to better valuations could be utilized to add to portfolios.
Global credit outlook
When it comes to volatility, troubles earlier this year at New York Community Bancorp (NYCB) may have reminded investors of the collapse of Silicon Valley Bank last year–and the subsequent contagion that led to the failure of Signature Bank. Decisive government intervention allayed fears of a broader banking sector crisis, but events at NYCB have highlighted lingering concerns about US regional banks.
The market reaction to events at NYCB may have been overdone–and the situation at NYCB is likely more idiosyncratic and not representative of the broader regional banking sector. NYCB has a more monoline business structure than the average regional bank, with a heavy concentration in multi-family and office commercial real estate loans. The broader message from NYCB’s recent troubles is that last year’s banking sector concerns and the risks surrounding commercial real estate (CRE) are still present. Both large systemically important global banks and regional banks have CRE exposure. However, the important factors to consider are the different sizes and types of CRE exposure relative to banks’ balance sheets and their levels of reserves.
Most banks are well-positioned to weather CRE challenges. Most US regional banks and banks classified as ‘globally systemically important banks’ have diversified commercial real estate portfolios across retail, industrial, office, and multi-family properties. Even though the smaller regional and community banks have higher asset concentrations, risks are likely to be mitigated by the ability of the regulators to either wind down those institutions or for their assets to be acquired by larger banks. We believe contagion to the broader banking system is unlikely.
Middle East outlook
We hold a positive outlook for the Gulf countries in the Middle East, bolstered by structural economic reforms and macro-policy improvements over the past five years. These reforms have enhanced demographics and financial wealth, positioning Gulf states to potentially outperform other emerging markets and developed economies amidst global financial tightening or trade risks. Despite a sharp rise in geopolitical tensions, the region’s robust macroeconomic balance sheets and high savings mitigate risks alongside a pivot towards non-oil sectors.
Last year’s slowdown due to oil output cuts was counteracted by strong non-oil GDP growth driven by domestic demand, particularly in the services and construction sectors. Anticipated future spending in the Gulf, totalling $3.3 trillion in planned projects, underpins a resilient fixed capital investment outlook. While concerns exist over geopolitical escalations and potential policy missteps during the shift to a non-oil economy, proactive measures and proven support mechanisms offer stability. However, we maintain cautious vigilance towards ongoing developments.
The bottom line
With all these market dynamics considered, we favour being overweight risk, given the very positive macro backdrop. However, we favour keeping risks tightly controlled, as very tight valuations limit the potential upside for risky assets, in our view. We see opportunities in investment grade in the US and Europe and emerging markets with hard and local currency debt and high yields. Shorter-maturity high-yield bonds may be favoured in this environment. High-yield issuers and securities with clear paths to refinancing could perform better under these conditions. Creditworthiness increases in importance in a higher-cost-of-capital environment- meaning focus could be best spent on better-quality issuers within the high-yield spectrum.
