Executive Summary

 

Economic Outlook

• "Will they, won't they" remains center stage for central banks with the Federal Reserve (Fed) taking outsized importance.
• The projections suggest the Fed will cut rates only once this year, compared to earlier expectations of three cuts, but markets have not yet settled on when this cut will occur.
• But the exact timing of rate cuts may not matter as much as whether the pace is "too much or too little."
• A Taylor rule analysis suggests the Fed was behind the curve in 2022 and 2023 but may have moved into more restrictive territory recently.
• However, there are few signs of recession currently, with PGIM Quant's news-based recession sentiment indicators mild and the US labor market humming along.
• Meanwhile, inflation has made progress back toward the Fed's 2% target.
• Falling inflation in developed markets outside the US has provided room for a number of central banks to cut rates in response to weak economic activity.
• In Europe, the struggling manufacturing sector continues to weigh on economic growth.
• The European Central Bank (ECB) cut rates by 25bps in early June, but inflation remaining above its 2% target prevents the ECB from futher cutting rates too aggressively.
• The Bank of Japan (BoJ) ended its negative interest rate policy and brought rates positive for the first time since 2016. Nevertheless, yields remain low, contributing to a weak yen. To keep the yen from depreciating further, the BoJ announced a plan to reduce JGB purchases with details expected shortly.
• Growth in developed economies remains sound, while growth in China is slowly recovering.

 

Market Outlook

• The macro environment in the US continued to be supportive of risk assets in Q2 2024 with equities posting solid gains while fixed income returns finished the first half slightly down. While economic growth remains solid, the summer months have historically seen lower volumes and lackluster markets.
• November's US presidential election is also likely to impact markets, with equity market volatility typically increasing in the months leading up to elections.
• Nearly all of the S&P 500's first-quarter earnings were driven by the Magnificent 7. This extreme skew is likely to moderate over the coming quarters, with earnings growth for the rest of the market anticipated to improve.
• Stock valuations suggest that much of the optimism around economic and earnings growth has already been priced in, with the S&P 500 forward multiple well above historical averages.
• The stocks-bonds yield gap is now well below the historical average of 2.6%, suggesting an unfavorable risk-return profile for stocks relative to bonds.
• Fixed income assets have been under pressure and volatile, as expectations for the various plausible macro scenarios have waxed and waned.
• We expect rate volatility to continue and yields to remain elevated but range-bound.
• Credit fundamentals remain solid amid the supportive macro environment and low near-term recession likelihood. However, the historically narrow spreads for both high yield and investment grade credit amid tightening financial conditions are negatives.
• Commodities are likely to live up to their historical track record as late-cycle plays. Commodity prices have typically climbed with rising inflation and solid demand.