The year began with a bleak macroeconomic overview — with no end in sight on interest rate hikes by the US Federal Reserve, a looming recession and predictions of a pronounced growth slowdown in advanced economies.
Moving into the second half of the year, economists at Lombard Odier see two diverging trends on inflation happening: “high for long” will be the main ensuing narrative for developed economies, while China — the second largest economy — will see “low for long” in the coming quarters.
Speaking at the 2H2023 investment outlook media conference on May 30, the head of investment solutions for Asia, Yankai Shao, and Asia’s senior macro strategist, Homin Lee, says four topics remain in mind: disinflation and the coming pause in rate hikes, China’s non-inflationary rebound, banking sector fragilities and commercial real estate, and the coming boom in global capex.
US Fed to pause rate hikes
Lee predicts that the US Fed will finally pause its rate hikes while keeping the rates at this level for the foreseeable future or the next three to four quarters, a move which other central banks will replicate.
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This “high for long” strategy results from signs of stress within the banking system, in which Lee says the US Fed is caught between encouraging trends in disinflation and a slightly uncomfortable forecast and outlook, resulting in them settling on a “wait and see” approach.
A period of slowing inflation is anticipated after the series of rate hikes from the US Fed, but Lee says the latest inflation data from the UK and the US show that disinflation is not occurring as fast as markets expected, referring to the April data releases.
He adds that as overall demand continues to slow and food and energy prices remain stable and well below last year’s average, the main culprit behind the ongoing inflation is the services sector.
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However, Lee forecasts that the labour market will soften due to the impact of high rates and banking sector difficulties, as well as the credit tightening happening within the sector, which will culminate in the prediction of CPI inflation rate falling close to 3% in 4Q2023, and falling further below 3% next year.
“The bottom line is that we think we’re still close to peak rates.”
Lee expects the US Fed to compromise and keep inflation rates where they are to avoid adding more pressure on the economy, resulting in “high for long” as the main strategy.
Meanwhile, he expects the European central bank to carry out one final rate hike in June before putting a pause, as data shows that Europe is still battling strong inflation.
China to maintain solid growth
On the other hand, Lee forecasts that China will adopt a “low for long” policy to cultivate a pro-growth environment that will bring the country to its GDP target of 5.5%, already the lowest target in a quarter-century.
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The macroeconomic strategist notes that there have been questions about the strength of China’s rebound in 2Q2023 after a strong Q1 rebound, while acknowledging that data indicators are not as strong as markets had hoped.
Lee believes that the fragilities in the manufacturing and real estate sectors are not exclusive to China, while doubts about purchasing real estate are a normal result of households exiting a difficult period of the zero-Covid policy.
“Our guess is that Beijing will try to boost credit a bit more in the next few months,” says Lee, “[so that] households can take advantage of attractive borrowing terms.”
This “low for long” policy recommendation will help China maintain solid growth, all without exporting inflation to the rest of the world, he adds.
Lee also notes that the use of emergency facilities for liquidity has been relatively stable and much smaller than what markets had expected initially, indicating that the overall banking system in the US remains stable enough. However, he cautions that lending standards need further tightening to avoid future fallouts.
Balanced approach ahead
Using historical data to predict future investment trends, Shao — who heads investment solutions in Asia for Lombard Odier — says 2023 is suitable for a more balanced investment approach.
As disinflation is anticipated in the coming months, a slowdown in economic growth will follow. Historically, the 12-month total returns after final rate hikes by the US Fed have been reliably positive for bonds, says Shao, who calls for overweight on bonds.
Likewise, for fixed income, Shao prefers investment grade over riskier high yields, favouring developed markets over emerging ones.
Meanwhile, the expected performance of equities after the previous seven rate hike cycles will remain unclear. Shao says the data shows ups and downs, leading him to remain “neutral” on the equities market.
He adds that despite stabilising financial conditions, institutional and retail investors continue to hold on to their cash, curbing the strong cash flow back into the US equities market, prompting him to call “underweight” on this asset class.
While high interest rates may benefit the US dollar, Shao says that the differential will diminish, and the dollar will revert to its long-term average or weaken in the year’s second half.
Finally, as gold is very sensitive to interest rates, Shao predicts that once a pivot occurs around September, gold will react “very positively”. He also highlights that central banks of emerging markets have increased their gold holdings in recent years, which provides good downside support for gold.
