CONTRIBUTORS
Paul Mielczarski
Head of Global Macro Strategy,
Brandywine Global
The macroeconomic backdrop is becoming increasingly favorable for G10 bond markets after a difficult start to the year. Hot US inflation prints in the first quarter raised doubts about the Federal Reserve’s (Fed’s) ability to cut rates in 2024. However, more recent data show a resumption of the disinflationary trend. Meanwhile, US growth has slowed to a trend-like rate, and further weakness may be in store as the economy adjusts to high interest rates and reduced fiscal support. Overall, we expect slower nominal gross domestic product (GDP) growth across G10 economies. In turn, this slowdown will enable central banks to lower policy rates from restrictive levels, supporting bond market returns. However, while it feels as if the macroeconomic ship is now sailing smoothly toward something resembling normal, it is important to remember that this is all still uncharted waters. And farther out, the economy is headed toward perhaps even greater uncertainties. One uncertainty is the lack of any historical precedent for the current economic cycle and ongoing post-pandemic rebalancing. But another complicating factor for investors is the upcoming US election, which has the potential to generate significant volatility across a wide range of asset markets.
Something closer to normal
During the past two years, we have already made significant progress in reducing inflation (see Exhibit 1). The upside surprises in US inflation during the first quarter were concentrated in service sectors, in which the lags with economic activity are particularly long. In essence, high inflation in these sectors is the result of shocks from two to three years ago, rather than current economic conditions. Goods price inflation, which responds faster to current demand/supply imbalances, is already back to its pre-pandemic run rate. The unit labor cost growth rate is slowing, reflecting labor market rebalancing and faster productivity growth. Meanwhile, shelter inflation should continue to decelerate in the months ahead due to more benign market rent trends.
Exhibit 1: US Core Personal Consumption Expenditures (PCE) Price Index
6-Month Average of Month-Over-Month Change, Annualized
As of May 31, 2024
Source: Macrobond. There is no assurance any forecast, projection or estimate will be realized.
Growth drivers rebalancing
We expect some additional moderation in US economic growth going forward as well as a rebalancing of its relative drivers. Government spending and service consumption have contributed disproportionately to GDP in recent years. We should see lower growth contributions from these sectors in the future. Monetary policy is restrictive and a headwind to economic growth. This tightness is reflected in very soft private sector credit growth, stress across commercial real estate markets, rising credit card delinquencies, and weak small business confidence surveys.
It appears that recession risks are relatively low at this point, particularly if the Fed cuts rates this year. However, we recognize that the current economic cycle is unique and without obvious historical comparisons. In light of this lack of past parallels, we remain openminded about recession risks and are closely monitoring economic data. It is possible that a large slowdown in service spending together with less fiscal support could potentially lead to a deeper retrenchment in labor demand and a higher unemployment rate. The labor market has shown very mixed signs recently, with strong headline employment growth contrasted by a rising unemployment rate, soft survey indicators of employment, and falling temporary help employment. It is noteworthy that the Fed expects the unemployment rate to finish the year at 4%. Since we are already at this level, any further softening in labor markets could trigger a more aggressive easing cycle.
Eurozone economic growth has improved in recent months as falling inflation boosted real consumer incomes and allowed the European Central Bank (ECB) to cut rates. However, the upcoming French elections have introduced a large element of political uncertainty going into the second half of 2024. In the event of a divided government, the broader economic impact on the eurozone is likely to be relatively short-lived. However, if the National Rally (RN) party wins an outright majority, that could lead to a sustained increase in sovereign risk premiums across the eurozone, undermining recent economic growth improvements.
With inflation moderating across developed market economies, central banks in the eurozone, Canada, Sweden, and Switzerland have already cut policy rates. The Fed is priced for 160 basis points (bps) of rate cuts over the next 3 years. If our inflation view is right—that is, inflation should continue to moderate as lagging service components catch up to goods price disinflation—the Fed should be able to deliver what is priced into the money market curve, starting with two 25 bps cuts later this year. It is very unlikely that the Fed will need to hike rates again in this monetary cycle. But we could see a number of scenarios in which policy rates are cut more aggressively than what is priced in. In the event of a deeper slowdown in growth or a large selloff in risky assets, bonds offer an attractive asymmetry and portfolio protection, in our view.
Electing a cautious approach
Recent elections in Mexico, South Africa, India, and the European Union caused large bouts of market volatility. And November could bring even bigger disruptions. The US elections in November could have major implications for fiscal policy, trade policy, and international relations. For example, looking at the massive scope of potential trade implications, if all of Donald Trump’s trade policy proposals are implemented, US tariffs would reach their highest levels since the 1930s. Granted, it is hard to know how much is campaign rhetoric or what the timing of any proposed trade restrictions might be.
However, even if half of the current proposals are implemented, 70 years of US trade liberalization will be reversed. It is very difficult to estimate the impact of such a large policy shift on financial markets. So, while moderating inflation and growth may feel constructive now, we believe markets will shift their focus from the timing of the Fed’s first cut to election polling during the second half of the year. At some point, a more conservative approach to position sizing will be warranted because of the possibility of large market shocks in the fourth quarter.
Read the full Mid-year outlook from Brandywine Global.
Definitions:
Core PCE Price Index, or the Personal Consumption Expenditures Price Index, Excluding Food and Energy is published by the US Bureau of Economic Analysis and measures the prices paid by consumers for goods and services without the volatility caused by movements in food and energy prices to reveal underlying inflation trends. It is the Federal Reserve’s preferred index for tracking inflation.
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