Unprecedented rate hikes and diminished liquidity have not led to the hard landing many feared. Episodes of tightening financial conditions impacted LDI in the UK and regional US banks, but we haven't had a financial crisis.
Earnings have not collapsed as many expected - companies have stronger balance sheets and been able to pass costs to consumers.
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The disinflation narrative has traction, and fiscal stimulus incentives in the US have seen increased manufacturing construction spending (via the Inflation Reduction and CHIPS Acts), despite tighter bank lending standards. Housing has also picked up, having slowed sharply given low inventory.
Credit sensitive areas are not responding to higher rates as they typically would. Furthermore, Covid distortions have resulted in consumer resilience, services sector strength and tight labour markets.
With resilient economic growth and central banks close to peak rates, the narrative has shifted to hopes of a soft landing or no landing scenario.
Moreover, we have not had a ‘black swan' event, but rather a less anticipated ‘golden swan'. The Generative AI narrative has propelled the ‘Magnificent Seven' - comprising Alphabet, Apple, Meta, Microsoft, Amazon, Nvidia, and Tesla to new highs and supported equity market sentiment more broadly.
Fears avoided or complacency?
But have fears been avoided, or just not realised yet? Are markets being too complacent?
Many challenges remain. We have not felt the full impact of aggressive rate hikes, which act with a lag before filtering into the real economy.
Fiscal dynamics are set to deteriorate and a new wave of issuance risks crowding out corners of the market and worsen liquidity conditions for corporates.
Fragility could still lurk in shadow banking and private assets. A financial market recession could precede an economic one.
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Manufacturing PMIs remain weak but are stabilising. Resilient services data is softening with consumer spending slowing as savings buffers get depleted and delinquencies rise.
Labour markets are usually the last shoe to drop. In the US, labour markets are cooling in an orderly fashion, with job openings falling and the unemployment rate rising.
However, labour markets remain tight. Central banks are cautious about declaring victory too soon in their battle against sticky inflation, hence rates are likely to be higher for longer.
The path down to 2% is unlikely to be linear. With winter a few months away, a cold snap could see inflation inflect higher, especially given our analysts' view that energy productivity will be structurally lower - feeding into rising cost curves. Indeed, oil prices recently topped $90 for the first time this year.
While developed central banks remain ‘data dependent', resilient growth and accelerating inflation could lead to the risk of a policy mistake by overtightening.
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The destination is likely to diverge across regions given the fragmented landscape.
US exceptionalism looks set to continue for a while longer thanks to resilient economic activity, meanwhile Europe is likely to slip into a recession by year-end.
China's economy continues to decelerate to a near stall and has slipped into deflation. With a crisis of confidence, falling prices may further lead consumers to delay spending, and hence companies too.
While Chinese authorities have stepped up efforts to support growth, it has been piecemeal so far and short of large stimulus.
We expect a continued slowly escalating set of policies aimed at keeping growth near 5%, while not abandoning policy priorities focused on deleveraging and restructuring the economy.
Agile diversification
The tide can change rapidly in markets. It is prudent to be diversified across geography, style and asset class.
Given higher inflation and rates, alongside liquidity removal, we should see elevated volatility ahead. But volatility is not risk and could provide compelling opportunities to add into weakness.
A focus on quality, profits resilience, durable growth and relative valuations will matter most in building resilient portfolios.
Concentrated gains and extended valuations in certain segments may allow laggards to gain ground.
Small cap stocks have been shunned and tend to do well in periods following regime changes.
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Japanese equities have rallied this year, but valuations still look compelling. Structural changes and cyclical tailwinds, with inflation stimulating consumption and improving corporate governance, automation and digitisation providing compelling opportunities.
While equity pricing looks at odds with slowing growth, bond valuations look more appealing. Enticing yields offer opportunity to lock in income.
However, it could be costly to extend duration too soon, given an inverted yield curve.
We are overweight high yield and emerging market debt. Going global also provides opportunities in areas with steeper curves and positive slopes.
Real assets and select commodities could provide inflation protection and additional diversification.
Asset prices are based on expectations. If expectations are wrong, sentiment could be susceptible to trip wires. Being agile and diversified can help navigate conflicting narratives.
Ritu Vohora is a capital markets specialist at T. Rowe Price