Soft landing remains most likely scenario

The eurozone economy and the Chinese economy are bottoming out. The US economy is gradually cooling somewhat, with growth in the second half of this year moving to a pace just below trend. This is in line with our expected scenario of a ‘soft landing’ of the economy: a situation where inflation declines while a recession is being avoided. Inflation has already fallen sharply. And we think that decline will continue in the coming months, bringing the target of the Fed and the ECB – an inflation level of 2% – ever closer.

Lower inflation enables these central banks to cut interest rates. At its policy meeting on 6 June, the ECB delivered a first rate cut, as expected. At the time, however, ECB President Christine Lagarde struck a cautious tone with regard to future interest rate cuts. We therefore believe that the ECB will pause in July, before cutting rates again in September.

In the US, inflation has proven more sticky. As a result, the Fed left interest rates unchanged at its June 12 policy meeting. But while some economists in recent months started to fear that the Fed would actually raise rates again, that scenario now seems to be off the table. Inflationary pressures in the US are gradually easing. We therefore expect the Fed to deliver its first rate cut in September.

The combination of continued growth and declining inflation offers a favourable investment environment for equities. So far this year, equities – led by US markets – have performed well. In recent weeks, market sentiment has been positive too, with equity indices hitting new record levels, both in Europe and the US. And in both regions, earnings expectations for the coming 12 months are improving. Higher corporate earnings are good news for investors. All in all, we see reason enough to remain slightly overweight equities.

Although the eurozone economy is starting to recover, the US economy is still in better shape. Moreover, the political situation in Europe has become somewhat more uncertain in the short term, with French President Emmanuel Macron calling early parliamentary elections. At the regional level, we prefer US equities (overweight) over European equities (underweight). Our view on emerging markets remains neutral.

At the sector level, we suggest that investors make two changes. First, we now prefer a neutral allocation to the information technology (IT) sector (previously slightly overweight). So far this year, the IT sector has shown very solid stock market performance. But this is mainly due to a surge in semiconductor stocks, as this sub-sector benefits from a huge demand for chips for AI applications. We now believe there is a risk that the optimistic sentiment surrounding semiconductor stocks has gone a little too far.

In addition, IT stock valuations have risen sharply. We therefore think it is wise to take some profit on stocks in this sector. However, we would like to emphasise that the long-term growth prospects of IT remain attractive.

The current high interest rates are favourable for the financial sector. Central banks will cut interest rates, but this will be a gradual process. For the time being, financials can continue to benefit from relatively high interest rates. Against this backdrop, we suggest investors to increase their position in this sector from slightly underweight to neutral.

In light of the expected soft landing of the economy, we no longer believe that an underweight of the financial sector is justified. In May, we had already added a modestly cyclical tilt to our sector positioning. By increasing the weighting of financials, we are now placing that emphasis a little more heavily. Our further sector positioning includes an overweight in industrials and an underweight in consumer staples.

Bond yields have risen sharply over the past few years and are still at much higher levels than they have been for most of the past decade. This applies not only to corporate bonds, but also to government bonds such as German Bunds and US Treasuries.

Last week, we have seen a remarkable rise in French government bond yields. Due to political developments in France, investors are now pricing in more risk for these bonds. But otherwise, bond markets are mainly driven by expectations about central bank policies. As we expect central banks to cut rates, we consider bonds to be attractive (bond prices move inversely to bond yields). We therefore maintain our slight overweight on this asset class.

Our preference is for high-quality bonds, such as government bonds and investment-grade corporate bonds, while we remain underweight riskier bonds, such as high yield. Over the past few months, we have incrementally increased the duration (interest rate sensitivity) in our bond portfolios. The higher the duration of a bond, the more the value of that bond will increase when interest rates decline.

At this point, we cannot rule out the possibility that inflation will prove to be more sticky than we expect. But that is not our base case. The world economy is converging towards trend growth and further disinflation is expected, which makes it likely that a soft landing scenario will eventually play out. For investors, this justifies taking on some risk in their portfolios.