As we move into the second half of the year, the latest data indicates a slowing pace of economic growth and a broad-based easing of price pressures.
Recent market volatility has intensified following softer US economic data, particularly the weaker non-farm payroll report last Friday. The downturn in US data has heightened market concerns about a potential recession, with rate cut probabilities rising significantly. Markets are now pricing in a 50bps cut in September and around 120bps for the year. Increased speculation about potential emergency cuts has emerged in response to the sharp equity sell-off seen over the last few days.
This turbulence follows a hawkish Bank of Japan which increased rates by 25bps last week in stark contrast to dovishness elsewhere around the globe. Consequently, the interest rate differential between the US and Japan has narrowed significantly, pushing USD/JPY lower. This has triggered a swift exit from highly leveraged carry trades, with investors liquidating higher-yielding assets to buy back yen. While some degree of carry unwind was anticipated due to the Fed's recent dovish comments, the rapid pace over the last few days has certainly come as a surprise.
Despite these developments, the data so far indicates growth moderation rather than an immediate recession. We have recently increased our recession probability to 30%, yet we still foresee a soft landing as the primary scenario. We believe the market reaction is more knee-jerk and primarily driven by technical factors rather than data flow. We therefore expect the US Federal Reserve to start cutting rates in September and the if volatility continues, to affirm their readiness to act if market turmoil impacts liquidity conditions and monetary policy outlook. Yellen could also influence conditions via the Treasury. This all points to a higher volatility environment looking forward than the past 12 months but still one in which you are rewarded to take risk in the right areas. Beyond 2024, the economic trajectory will depend on the US election outcomes and subsequent policy changes.
Our core view remains risk on with a preference for equity, albeit we are actively managing it through volatility and weaker seasonal periods. We are taking risk selectively looking to take advantage of dislocations in markets, for example our preferences for mid-cap stocks and southern European equity. We are also looking for areas to take profits in order to keep some powder dry, such as our exposure to duration. Our models were already showing signs of moderation and the team are monitoring the signals and data prints closely, to see if this is indeed a soft patch or has the potential to develop into something more.
