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Quarterly Market Outlook: Q2 2023

Final calibration: The pause is near

We are approaching the expected moment when the central banks would press the pause button on one of the fastest and steepest rate hike cycles in recent history. The current phase of monetary policy calibration is particularly complex. Central banks face a significant challenge in their upcoming decisions as they must manage the confluence of three factors: persistent inflation, liquidity tensions in the financial system and the lagged effects of rate hikes in the economy.

Economic activity has been stronger than expected in the first quarter of the year both in the US and Europe. Robust job creation has continued to provide support for private consumption. However, there are signs of weakness in leading indicators, and we expect a significant deterioration of credit conditions in the coming quarters. The present economic backdrop together with asset valuation call for caution in risk assets. Yield is back in high credit quality bonds and government bonds offering compelling value versus equities.

01. Monetary policy pause is near

After one of the most dramatic monetary tightening processes in history, we are approaching the time of a pause in interest rate hikes. Central banks are about to enter a calibration phase of monetary policy which is highly complex due to persistently high core inflation. Although it is true that the headline inflation peak is behind us in the US and the Eurozone, this improvement is far from being widespread. Services and food inflation have yet to peak. In the US the labor market is still robust and the elevated number of unfilled vacancies keeps upward pressure on services inflation. Recent bouts of instability in the financial system add further complexity to the central banks' roadmap.

Time has come for calibration as market doubts whether the monetary tightening is sufficient

Interest rates remain range-bound and the risk of further increases appears to be limited

02. No pivot without slowdown

Market consensus expected economic weakness in the first few months of 2023, but the vast majority of incoming economic data have been surprisingly resilient. The reopening of the Chinese economy, the absence of energy supply problems in Europe and the strength of consumer spending in the United States have allowed central banks to maintain the pace of rate hikes. We expect a turnaround in the coming months as household consumption could lose steam and the effects of credit tightening could take a toll on investment decisions. We believe that the pivot will only be announced when services inflation moderates and signs of weakening economic growth become evident.

The Federal Reserve dual mandate is currently skewed towards inflation

Inflation is well above its target while unemployment is still at record lows

03. Fixed income finally offers “income”

Our growth and inflation projections envisage an environment that favors an overweight in core fixed income over assets that are more sensitive to the economic cycle (high yield bonds and equities). An analysis of current valuation levels relative to history reinforces the allure of bonds after investors were starved for yield for years.

Investors no longer need to stretch out of bonds for income

Yields have come a long way and fixed income is attractive again


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