Monthly Macro Update, May 2023
Nearly a year and five percentage points later, the U.S. Federal Reserve’s tightening cycle may have finally run its course. Whether the Fed has the room to cut rates in coming months is less certain, depending on the resilience in employment and inflation pressures, as well as lingering bank sector tensions.
Still, a pause by the Fed tends to be positive for high-carry strategies, with emerging market (“EM”) local debt as a compelling way to gain exposure, argued The Rohatyn Group’s (“TRG”) macro analysts and portfolio managers in their monthly Global Strategy Meeting (“GSM”) discussion about themes shaping the outlook for markets. As the U.S. debate keeps shifting towards the timing of eventual rate cuts, the consumer-led recovery in China remains on track – with the recent unwinding of some of the reopening trades saying little about the good prospects for the rebound. Peak U.S. rates and China’s stable growth footing suggest diminishing macro tail risks, many participants agreed; an environment in which idiosyncratic opportunities are likely to keep driving market performance in 2023.
Inflection in Rates
The early May quarter-point rate hike likely marked the end of the Fed’s tightening cycle, GSM participants thought. Though policymakers did not rule out additional moves, the statement’s tone turned neutral, excluding March’s phrase about the need for “some additional policy firming.” Tensions in the banking system and tightening in lending conditions support the case for a pause; the recent Senior Loan Officer Survey conducted by the Fed confirmed ongoing tightening,
even if not quite the sudden-stop feared after multiple bank failures. Regarding the market’s expectations for rate cuts starting in the third quarter, GSM participants
highlighted that at least for now Fed comments suggest the bar for rate cuts is relatively high as incoming data does not point to a meaningful growth slowdown. Risk
takers argued that, even if rates stay high for longer, it is good news that the focus keeps shifting from the extent of tightening to, now, the timing and magnitude of rate cuts. A Fed no longer in tightening mode, moreover, should provide maneuvering room for some EM central banks to start cutting rates.
Implications from China
If the debate about the outlook for the U.S. economy yielded a wide range of views, the discussion about China’s was the opposite: the consumption-led recovery is advancing rapidly, and momentum is positive (see Figure 1). Very low inflation, moreover, provides room for policy to stay accommodative even as savings-rich consumers keep spending. Participants highlighted China equity underperformance and disappointing performance of many trades – such as long Thai Baht, South Korean won, and commodities linked to the reopening. Part of the unwinding may reflect the consumer-centric nature of the rebound, which involves more limited and protracted global spillovers; participants also speculated that concerns over the sustainability of the apparent probusiness policy tilt and geopolitics may be limiting strategic inflows by global investors. The low-yielding Chinese Yuan seems less compelling given highcarry opportunities elsewhere. Selectivity in equities remains important, and with China growth prospects still positive, there may be a window to revisit some recovery trades.
“Peak U.S. rates and China’s stable growth footing suggest diminishing macro tail risks, many participants agreed; an
environment in which idiosyncratic opportunities are likely to keep driving market performance in 2023.”
U.S. Transition
We believe the U.S. economy is shifting to a “reflation” regime of central bank easing and moderating inflation from one of “stagflation” characterized by above-trend inflation and weakening growth. That continues to be the message from TRG’s analysis of the business cycle. The progress towards “reflation” will depend on the interplay between the economy and inflation trends. This dynamic has important implications for asset allocation. Incoming data, however, continues to paint a mixed picture and GSM participants thought it would be a bumpy path, including the risk of recession. There are signs of some moderation in labor markets and gradual easing in inflation pressures (see Figure 2); global trade is sluggish, and sentiment indicators point to weakness. Consumption looks resilient and the drawdown in excess savings may be cushioning the adjustment through year end. Unresolved banking sector issues add another layer of uncertainty and downside risks to the outlook.
EM Opportunities
Fixed income specialists continued to favor exposure to high carry strategies through local EM debt. While this asset class performed well so far this year, it has historically gained ground after a Fed pause (which may have occurred in May). The transition to a “reflation” regime increases the appeal of long-duration exposure as the curve bull steepens, too. Most of the GSM contributors see further scope for dollar depreciation; Europe’s growth outlook (and its implications for the euro) and the debt ceiling standoff are near-term risks that could make the dollar path bumpy. On the equity front, portfolio managers stressed the need to remain selective to capitalize on compelling valuations and fundamentals – the wide dispersion of returns in 2023 and unwinding of China trades supports this approach. Reduced macro tail risks – principally from peak Fed funds and China’s growth momentum – should reinforce high differentiation and stock picking as a driver of market performance.
