Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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US rate cut seems distant as inflation report looms
Peter Garnry
Chief Investment Strategist
Key points
- Nonfarm Payrolls impact on rate cuts: The upside surprise in the US Nonfarm Payrolls has shifted market expectations, now predicting only one rate cut in December, a significant change from the seven cuts anticipated at the beginning of the year and the Fed's forecast of three cuts. This shift suggests the Fed is becoming more cautious and delaying the rate cut cycle due to inaccuracies in its own models.
- Nowcasting in economic forecasting: The concept of nowcasting, which involves short-term forecasting of key economic indicators, is highlighted as a valuable tool amidst noisy macroeconomic data. Using real-time data sources like the Redbook same-store sales index and the Dallas Fed Weekly Economic Index can provide more accurate predictions, reflecting the recent acceleration in the US economy.
- Current economic and market conditions: Positive performance in risk-on asset classes such as developed and emerging market equities contrasts with the negative performance in commodities, private equity, and small caps. The global economic backdrop remains positive, with no stress signals from financial markets, supporting a favorable environment for equities and other risk-on assets.
The value of nowcasting as Nonfarm Payrolls shock investors
Ahead of Friday’s upside surprise on US Nonfarm Payrolls market pricing was evenly divided between the Fed cutting rates either at the September or November meeting. As we will soon publish in our Q3 quarterly outlook our view is that the economy and markets will hum along in Q3 and that macroeconomic indicators are generally supporting this view. Our views have generally been on the positive side and we have multiple times spoken into resilient US data and that inflation would surprise to the upside. After the Nonfarm Payrolls figures on Friday the market is now only pricing in one rate cut and earliest at the December meeting. Quite far from the seven rate cuts priced in at the beginning of the year and the Fed’s own forecast this year for three rate cuts. The fact that the Fed’s own models have been wrong again is likely making the Fed more cautious and thus delaying the rate cut cycle.
There is so much noise in macro indicators right now that it can be difficult to choose what to put a weight on. In our team, we are putting weight on the concept of nowcasting. The idea is to keep the forecasting horizon short (hence nowcast) and predicting key economic indicators such as real GDP that are published with a significant lag. If one had used the two weekly series called the Redbook same-store sales index and the Dallas Fed Weekly Economic Index then you would not have been surprised about the latest developments. The US economy has accelerated over the past couple of months. The advantage of using nowcasting is that you avoid making longer term predictions based on weak causality, but instead you go with the methodology applied in weather forecasting. If the current state is sunny weather then the likelihood of sunny weather tomorrow is very high. It is basically the same with the economy.
US May inflation report is this week’s key event
For asset allocation portfolios and investors watching the macro economy this week’s most important report is the US May inflation report on Wednesday. With the core CPI services less housing (supercore measure) reading at 0.42% MoM in April, the sticky part of inflation seems to be stuck around 5% annualised inflation. If we get another reading like this then a rate hike is almost impossible unless there is a materially decline in economic activity. Add to this that wage pressures and financial conditions continue to support demand and inflationary dynamics.
Positive backdrop in most asset classes with commodities still weak
The past week has seen good performance for risk-on asset classes such as developed (+2.6% ) and emerging market equities (+2.2%) followed by convertible bonds (+1.4%). In the bottom we find negative performance across listed private equity (-0.9%), commodities (-0.8%), and developed small caps (-0.3%). In commodities, the weakness has been driven by first lower energy prices and recently weak metals prices as China’s macro data continue to paint a mixed signal.
With a positive backdrop from the global economy and financial markets not sending any stress signals we expect to continue being in a positive environment for equities and generally risk-on assets.
Previous notes on asset allocation and macro
Commodities setback, investment drought in mining, and EM elections (3 June 2024)
The inflation conundrum and private equity party (27 May 2024)
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