A balancing act between expectations and reality

• Mixed data causing equity volatility: Last week, US inflation slowed less than expected. This caused equity and bond prices to fall and the US dollar to rise as markets quickly reevaluated their expectations of rate cuts from the US Federal Reserve (Fed). However, the higher-than-expected inflation rate was followed by lower-than-expected January retail sales, tempering fears that the US economy may be overheating. This revived odds that the Fed could start cutting rates in June and US equities quickly bounced back to their record levels.
  
  
• Bond market rate expectations becoming more realistic: Despite the rebound from equities mentioned above, bonds remained on the back foot. We think the bond market had previously gone too far in terms of rate cut expectations, which has led to higher yields / lower prices (though the peak in yields / bottom in prices has likely passed). Markets are now aligning with our view of rate cuts amounting to one percentage point starting around mid-year, though we expect volatility to continue as economic data come in.
  
  
• Emerging markets gain back some ground: Despite a mildly stronger US dollar, emerging markets equities outperformed their developed markets peers last week. With Chinese markets closed for the Lunar New Year, their poor performance wasn’t there to drag the broader emerging markets down. Hong Kong markets, while closed for part of the week, reopened higher on Wednesday following local media reporting a surge in Chinese travel demand over holiday. This drove up hopes that consumer spending was recovering from a three-year period of weakness. We are still cautious on China as we think the recent rescue packages may only have a short-term impact in the absence of structural stimulus. Our exposure to emerging market equities is in line with our long-term asset allocation.
  
  
• Not all doom and gloom despite mild recessions in some key countries: Germany, the UK and Japan were all in a moderate recession in the last two quarters of 2023. But it’s not all bad news. Firstly, the Netherlands exited its shallow recession, while revised data showed that the Eurozone is yet to fall into one, trending at just zero-growth. Secondly, consumer surveys are improving, and economic activity seems to have bottomed out in the Eurozone. Thirdly, Japanese equities charged to the all-time high last reached in 1990 and the mild recession may impact the Bank of Japan’s timing of when to exit its negative interest rate policy. Finally, weaker growth momentum in the UK had the Chancellor of the Exchequer, Jeremy Hunt, alluding to potential tax cuts in the Spring Budget, though the strong retail sales number in January may not call for them.

• Getting back to balanced: For about a year and a half, we’ve held fewer equities and more bonds in portfolios compared to our long-term strategy. In February, we brought both back to neutral. This means increasing equities and reducing bonds.
  
  
• Increased equities: Given the reduced likelihood of a US recession, we closed our low-volatility US equity position and increased holdings in global small caps and the broader US market. However, as a recession is still the most likely scenario in the Eurozone, we still hold fewer Eurozone equities than normal; relative to our strategic allocation, we prefer European low-volatility /defensive sectors such a health care, consumer staples and utilities.
  
  
• Adding high quality European credit: We’re increasing our exposure to European investment grade credit as valuations are attractive. To fund this, we’re reducing our exposure to US bonds and European/UK government bonds, which are less attractively valued. Also, we’re maintaining a reduced exposure to riskier, high-yield credit markets.
  
  
• For a detailed overview of our allocation in flagship portfolios, please visit our latest Counterpoint.

• Nvidia earnings: Nvidia will release its earnings data on Wednesday, and it could be one of the most important of the season. Nvidia is the third largest company in the US by market capitalisation and top performer in the S&P 500 so far this year (+46%). We don’t doubt the long-term strength in the AI trend. However, Nvidia’s guidance as the bellwether for tech and mega-cap stocks will be key in assessing if their earnings are sustainable and can continue to grow, or if there’s a risk of a correction after such an exponential rise.
  
  
• Minutes to a cut: Investors will look for hints on the timing of the first Fed rate cut following the release of the minutes of its January meeting (Wednesday). We believe the Fed will look for more evidence of good data, i.e. lower inflation, before starting to cut interest rates around mid-year.
  
  
• Green shoots? It may still be too early to call for a sustainable recovery in the Eurozone just yet. That said, the purchasing managers’ indices (Thursday) are expected to show a continued improvement, but still in contraction territory.
  
  

Past performance is not a reliable indicator of future returns.