Rate cuts come into view
The interest rate outlook was a key driver of stock markets in 2022 and 2023 but it has been less of a dominant force this year. However, following a busy few weeks for central bank meetings, monetary policy is coming back into focus. Markets have generally reacted positively, even in response to the Bank of Japan’s first interest rate increase since 2007. Elsewhere, the talk is of interest rate cuts. In his latest press conference, Federal Reserve Chair Jerome Powell said that the US central bank was still on track to cut rates this year, while acknowledging that the latest US inflation readings had been slightly higher than expected. Some investors took this as a signal that the Fed may be moving towards a slightly more tolerant view of inflation. US equities and gold both rallied in response to his comments and held onto their gains into early April.
All eyes on June
Growth in the UK and Eurozone remains anaemic, while headline inflation continues to fall. The Bank of England and European Central Bank have therefore signalled that they are also thinking about cutting interest rates. However, both remain slightly concerned about high rates of inflation in the services sector (just above 6% in the UK), which is being driven by tight labour markets and rising wages. Policymakers in both regions have said they want to see further evidence that services inflation is on a downward trend before starting to cut rates. Markets have concluded that the ECB and the BoE will join the Fed in cutting interest rates over the summer, probably in June. If the three central banks do end up cutting rates at around the same time, it could provide a further boost to sentiment.
Preparing for a Trump Biden rematch
Unlike in the UK, the outcome of the next US election remains very unpredictable. The performance of the US stock market in the run-up to the vote may be a useful guide, according to recent research from Schroders’ economists. Historically, when the S&P500 has risen in the 3 months before an election, the incumbent president or party has tended to be re-elected. When it falls, the incumbent has lost. This rule of thumb does not have a perfect track record, but it has proved a reliable indicator since 1980. Our economists have also introduced a new risk scenario to their outlook, reflecting the possibility of US presidential candidates making unaffordable spending pledges and spooking bond markets. While this is regarded as a low-risk scenario, it is one that we are mindful of.
Positioning
Our overall equity exposure is broadly in line with our long-term strategic targets. Japanese equities remain a core overweight and have boosted performance this year. We have also been increasing our US equity exposure, given the resilience of the US economy and a positive earnings outlook. With inflation stabilising and yields still at attractive levels, fixed income continues to look compelling. We prefer shorter-dated bonds, given attractive yields and continued uncertainty around the extent of interest rate cuts. We still see appeal in alternatives and have benefited from this year’s rally in gold, though we have been trimming our exposure to take advantage of opportunities in equities and fixed income. High levels of inflation in the UK have made meeting inflation-plus return targets more challenging in the near term. Despite this, we remain confident in the ability to meet inflation-plus targets over the longer term.
Key
🟢 Positive
⚪ Neutral
🔴 Negative
Outlook
| Economics | Interest rates are weighing on growth, but a soft landing looks increasingly likely as consumer demand remains resilient (particularly in the US).Headline inflation has fallen significantly, although core inflation is likely to remain above central bank targets.Labour markets have started to soften but are likely to remain tight in the near term, fuelling wage inflation.While sticky inflation and tight labour markets may delay rate cuts, central banks appear increasingly comfortable with cutting rates ahead of inflation returning to target, if the general trend remains disinflationary. |
| Valuations | US large cap equities remain expensive based on traditional metrics, but fundamentals are strong. Most other regions look fair vs history, but expensive vs cash and bonds.Credit spreads remain tight (especially in the US) although absolute yield levels remain reasonable as government bond yields are elevated relative to the last decade.Valuations of both equities and credit remain vulnerable to a meaningful deterioration in corporate earnings. |
| Sentiment | Investors are very bullish and volatility remains low.Consumer confidence has improved. It is close to 2-year highs across many developed markets, whilst China remains very weak.Business sentiment appears to have bottomed with most regions moving into positive territory, although Europe remains weak.Improving consumer and business confidence should be supportive for markets, although bullish investor sentiment makes markets more vulnerable to disappointment (e.g. around rate cuts). |
| Risks | A resurgence in inflation, which would warrant continued hawkish central bank policy.Labour market weakness could challenge the developed market growth outlook.Potential spillover effects from slowing growth in China on the global economy.Escalation in geopolitical tensions, e.g. Middle East, Russia/Ukraine, US/China.Large number of elections taking place, with the US election likely to create volatility.Mounting levels of government debt, particularly in the US, pose a longer-term risk. |
Asset Classes
| Asset classes | Current positioning | Current views |
| Equities | ⚪ | We are neutral equity having increased exposure over 2023. A peak in interest rates is supportive for equities, with falling inflation and softer labour markets raising the prospect of interest rate cuts. Corporate earnings were generally robust in 2023, but forward estimates are elevated. US valuations look expensive relative to history while other regions are expensive relative to bonds and cash. |
| Bonds | 🟢 | Government bond yields look attractive compared to the last decade. We prefer shorter duration assets, which should prove more resilient if inflation surprises to the upside – as has been the case this year. We continue to prefer the credit of higher quality issuers, as well as emerging market debt where yields are attractive and growth prospects are generally brighter. |
| Alternatives | 🔴 | Selective alternatives continue to offer diversification characteristics in a potentially volatile environment, albeit with a higher hurdle given yields available on bonds and cash. We favour assets with the ability to deliver less correlated returns to traditional markets and those which hedge against specific risk scenarios, such as commodities. |
| Cash | ⚪ | Rising interest rates offer more attractive returns relative to recent history, while cash allows us to take advantage of tactical opportunities in potentially volatile markets. |
Terms
Spread: the difference in yield between a non-government and government fixed income security.
Duration: approximate percentage change in the price of a bond for a 1% change in yield.
This article is issued by Cazenove Capital which is part of the Schroders Group and a trading name of Schroder & Co. Limited, 1 London Wall Place, London EC2Y 5AU. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority.
