Increasing confidence that we will see a soft landing for the American economy is being reflected in overseas stock markets, as well as on Wall Street.
While global inflation is falling -thanks in part to 18 months of interest rate hikes from central banks- the global economy looks likely to have only a shallow downturn, as the covid era economic cycle comes to an end.
But, subject to an individual’s investor profile, buying U.S. stocks may not be the best response. As inflation falls, more global bonds are likely to join U.S. Treasuries in offering positive real yields and so becoming increasingly attractive to investors. Meanwhile, U.S. stock markets continue to look richly valued compared to their overseas peers.
A diversified approach to investing, perhaps, subject to the specific investor profile, the use of muti-asset funds may remain the best approach for investors to achieve good long-term risk adjusted returns.
The S&P500 is up 3% over the last month (as of close on 28th July), the FTSE100 up 2.2%, the EuroStoxx 50 up 1.5% while the Japanese TOPIX is down 1.3%
The U.S. Federal Reserve  and the European Central Bank (ECB)  both raised interest rates by 25 bp last week, to a range of 5.25-5.5% for the Fed and to 3.75% for the ECB. But financial markets are betting that the peak of the cycle has now been reached by the Fed, while the ECB perhaps has two more to go.
Key to the good news on inflation is that core inflation is now falling in the U.S. and in most major economies. Core inflation has long been seen as problematic, in contrast to food and energy inflation that has largely rolled over since peaking in the first half of last year.
On Friday, the Fed’s preferred measure of inflation, the core personal consumption expenditure (PCE),  fell from 4.6% in May to 4.1% in June (the annual rate). This was its lowest since September 2021. It followed weaker-than-expected core inflation numbers from the eurozone last week and similarly surprises from the UK the week before.
But this is not happening against a background of mass unemployment and recession, as many economists had predicted at the start of the year. Far from it: last week the U.S. reported stronger than expected second quarter GDP growth, at 2.4% annualised (from 2% in Q1).
A soft landing for the U.S. would substantially decrease risks of recession elsewhere. And last week, the IMF upgraded global growth projections . It forecast the global economy to grow by 3% this year (its previous forecast, in April, was for 2.8% growth). The UK will avoid recession. The report praised the robust health of the global consumer, but noted that low productivity growth will keep longer term economic growth at a relatively subdued pace.
Positive real Treasury yields!
The current 2yr Treasury yield of 4.9% is almost 2% higher than June’s CPI inflation . That is, arguably, a generous real return for taking no risk. It is in contrast to the 1.5% dividend yield on the S&P500, and in sharp contrast to the relative valuations of much of the post-GFC period, when real returns on bonds were negative. Then there was a strong argument for holding equities, because at least they offered growth potential.
But the age of TINA (‘there is no alternative’ to buying equities) has gone with the return of positive real yields in Treasuries.
Elsewhere in bond land
Real yields are still firmly negative in the UK. Certainly, following June’s inflation data, the two-year gilt yield has fallen from 5.5% on the 6th of July, to 4.98% at close of Friday. But don’t forget that the better-than expected June’s data showed CPI inflation at 7.9% year-on-year, meaning a negative real yield only two-year gilt of around 3%. The UK inflation story is best described as ‘as not quite as awful as had been feared’.
Last week HSBC became the first major UK mortgage provider to announce cuts in mortgage rates across the full range of its offerings, in anticipation that interest rates are near peaking as inflation falls. We will hopefully have guidance on future rate hikes on Thursday, when the Bank of England is expected to raise its key rate by 25bps to 5.25%.
Yields have been rising in Japan on expectations of the Bank of Japan adjusting its massive quantitative easing programme, which is focused on keeping long-dated bond yields low through central bank purchases. As inflation has risen, the program has less support at home.
Sure enough, last week the Bank of Japan raised the cap on the ten-year JGB Yield, from 0.5% to 1%. At the same time, it described the 0.5% level as a ‘reference’ point. In response to the central bank taking a more relaxed approach to market prices, the 10-year JGB Yield rose to 0.57%, a nine year high . The yen has strengthened slightly in July, currently it sits at Y142 to the dollar.
If a soft landing does happen for the global economy, we can expect cyclical stocks to outperform in anticipation of the next economic cycle. The S&P500, with its high concentration of tech stocks at high valuations, does not look as an attractive investment as say, Europe or Japan. In these markets cyclical stocks have a larger weighting, and are available at cheaper valuations than their U.S. peers.
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