Capital Ideas^TM

Investors powered a broad rally in risk assets in the second quarter as recession concerns appeared to diminish. Equities gained and credit spreads tightened as banking sector worries receded for now and Congress passed a US debt ceiling bill. Treasury rates rose amid solid economic data and as officials at the Federal Reserve (Fed) pushed back on easing expectations. Markets appeared to be lowering the likelihood of policy rate cuts and more adverse growth scenarios in the near term. As a result, the yield curve inverted further, reversing the steepening that occurred in the depths of the banking crisis in March.

Growth may continue to be resilient even as it slows, but risks skew to the downside. Markets reflect a sanguine growth outlook as robust labour markets and wage growth - even with some softening - have underpinned a healthy consumer. Even as the manufacturing sector contracted, consumer spending has been durable and supported the services sector of the US economy. While a path to a “soft landing” or continued growth remains a possibility, the banking sector crisis has exacerbated a tightening in credit extension broadly and represents a headwind to growth. Furthermore, the global growth picture is mixed. Stubbornly elevated inflation in Europe has meant more restrictive central bank policy even as growth momentum wanes, particularly in the eurozone. China’s growth has also disappointed with the manufacturing sector stagnating and service sector recovery slowing.

Inflation in the US appears to be moderating. Headline Consumer Price Index (CPI) has decelerated to 3%, a sharp decline from last year’s peak at over 9%. The relatively “stickier” components, including shelter, are also off their highs. While goods inflation has slowed more quickly, even non-shelter services inflation - a measure often cited by the Fed - has been trending lower. This deceleration trend appears to be broadening, with over half of the CPI basket components reflecting inflation below 4%. Even so, strong wage growth and a resilient labour market are likely supporting the elevated rate for core inflation. The Fed has noted that their preferred inflation measures may not reach their 2% target for a few years.

Central banks have struck a hawkish tone recently, but inflation trends and the macro backdrop suggest further tightening may be limited. Officials likely want to counteract any unexpected easing in financial conditions and preserve optionality, but decelerating inflation suggests restrictive policy is having an effect. If inflation continues to slow and labour markets soften, growth considerations may play more of a role in the Fed’s policy decisions. The Fed could keep rates at elevated levels for some time, but markets may be underappreciating the potential for a more meaningful slowdown in growth and a resulting shift in the policy rate path.

While markets appear more optimistic, growth uncertainty and less compelling risk asset valuations warrant a more conservative stance. Traditional risk asset valuations appear less attractive and we favour a more selective approach, particularly if growth momentum slows further. After recent market moves, interest rate and curve exposures may offer better risk-reward trade-offs. Valuations also appear more compelling in mortgages and certain types of securitised credit, where compensation for the economic backdrop is more reasonable. In addition, dispersion within sectors of fixed income, such as corporate bonds, create attractive relative value opportunities that could offer better return potential than generically overweighting the sector.