Yields of US Treasury bonds have slipped since reaching around 3.12% in early May (see Exhibit 1). The rally has been driven by fears of a global recession due to poor economic data, strong inflation numbers, aggressive talk from central bankers and concerns over the consequences of Covid in China.
Recent data that contributed to the bond market’s unease about the prospects for the US economy includes:
- The Richmond Federal Reserve Manufacturing survey, which fell to its lowest since 2020 at -9.
- The monthly survey of manufacturers in New York State conducted by the Federal Reserve Bank of New York fell to -11.6, with the shipment measure falling at its fastest pace since the start of the pandemic two years ago.
- The Federal Reserve Bank of Philadelphia’s May business index dropped 15 points to 2.6, with the six-month outlook falling to its lowest since December 2008 (though the underlying details were better than the headline number).
- Existing and new home sales dropped for a third month, to its lowest since 2020, held back by lean inventory, rising prices and higher mortgage rates.
Taken together, the various regional Federal Reserve surveys suggest that the ISM Report for Business may come in at around 53, above 50 so still clearly in expansion territory for the US economy, but down noticeably from the upper 50s/lows 60s readings to which markets have become accustomed.
US equities still weak
US equities have remained weak as the down move continues for its seventh week.
It has been apparent that, in contrast to the start of the year when rising real bond yields were undermining equity markets, it is now fears of falling earnings due to a weaker economy that are weighing on stocks.
The last week has seen, in accordance with the risk-off regime, more buying-the-dip and selling-the-rally. There has also been a rotation out of growth and cyclicals into value and defensives (healthcare, real estate, utilities and staples).
European markets under the cosh
Bearish sentiment is prevalent in Europe, too, with investors cutting exposures to European equities.
There was another outflow in the week to 18 May, taking the total to 14 weeks of outflows in a row. Cyclicals, in particular, saw strong outflows, led by the materials, financials and energy sectors.
Our multi-asset team are inclined to reduce exposure to equity markets given the deterioration in the outlook.
European economy resists
Economic activity indicators have fallen so far in May, but remain above 50. Activity edged up in the manufacturing sector despite the fallout from the Ukraine war and supply chain disruptions that have intensified with China’s coronavirus lockdowns.
Although factories continue to report widespread supply constraints and diminished demand for goods amid elevated price pressures, the eurozone economy is being boosted by pent-up demand for services as pandemic-related restrictions are wound down.
While purchasing manager indices are still pointing to growth, it may be that these surveys understate the shock to activity, while sentiment surveys likely overstate the shock. Markets are increasingly tilting towards anticipation of a contraction in the coming quarters.
Higher food prices
Restrictions on the export of Ukrainian cereals continue and risks increasing food insecurity as the UN World Food Programme has highlighted.
As much of Russian and Ukrainian wheat goes to poorer nations, hunger could be a critical risk, driving up political instability.
The risk of further rises in food prices will be a key driver of inflation, particularly in emerging markets, the worst-case scenario being that the situation worsens significantly.
Moreover, lower fertiliser supply will have a greater impact on the next few months’ harvests, while the pass-through of costlier logistics and input prices is likely to drive food prices even higher.
Minutes of the meeting of the US Federal Open Markets Committee on 3-4 May will be published later on Wednesday.
However, market conditions have soured appreciably since the Fed's first 50bp rate rise, so some of the language in the minutes pertaining to financial risks and market conditions will be outdated.
Instead, the three major focus points for market participants will likely be:
- Policymakers' views on the conditions which could lead to a shift down, back to a pace of raising rates by 25bp at each FOMC meeting;
- Any hints as to how far and for how long policymakers intend to push policy rates into restrictive territory;
- Guidance shaping expectations for the next Summary of Economic Projections -- aka the dot plot -- due to be released at the June meeting.
Forthcoming economic data
US personal income and spending data for April should give investors an insight into the US consumer’s behaviour: Are they tightening the purse strings? The report may also show the Fed's preferred inflation gauge (core PCE deflator) starting to decelerate.
Perhaps equally important, the report should shed light on how consumers are responding to the current high inflation environment, indicating how wages are performing relative to inflation and how aggressively consumers are tapping into the USD 2.5 trillion of accumulated savings from the pandemic period.
Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. The views expressed in this podcast do not in any way constitute investment advice.
The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.
Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).
Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.