Economic history shows that soft-landings are highly unusual. It may be too early to declare beyond doubt that one has been achieved in this cycle, but policymakers and investors are feeling more optimistic. The US yield curve has been inverted (10-year bond yields below 2-year bond yields) - a classic warning of recession ahead - for two years, an unusually long time, but no US or global recession has yet arrived. There have been bumps along the way - regional and sectoral slowdowns, quarters of negative growth in Germany, the UK and elsewhere - but the resilience of US Services over Manufacturing, and signs of reacceleration in the UK, parts of Europe and Asia, have all offered support to the global economy when needed. Growth has been impacted by higher-for-longer interest rates, but both households and firms have been insulated by a benign combination of fixed-rate debt, reasonably strong balance sheets and relatively strong incomes.

Despite the resilient US economy, recession fears have not gone away and of course there are still risks ahead, as the delayed impacts of higher interest rates arrive. In the UK, short-term fixed rate mortgages continue to expire, rolling borrowers into higher repayments. Bank of England data show that 400,000 households face a rise in mortgage costs of at least 50%. In the US, long-term fixed rate mortgages protect existing borrowers from higher rates, but make housing purchases much more expensive, freezing the market: the average rate paid by new borrowers is about 3% higher than the cost of existing mortgage debt. As a result, fewer households are moving: the measure of pending home sales has collapsed to its lowest level since the series began in 2001. While US house prices are making new highs, housing activity is under pressure and prices of lumber (a key building material) have fallen a quarter since the spring. Meanwhile, default rates for companies and commercial real estate have been inching higher, catalysed by stretched borrowers having to refinance older maturing debts at today’s higher rates; and job openings are becoming scarcer, threatening to push up unemployment and increase pressure on consumers. So far, risks appear contained and the consensus is for US growth to slow in the second half before rebounding - soft landing achieved, with recession avoided. But past cycles have shown that sometimes optimism about a soft-landing takes root just as the economy is really slipping into recession. If reality falls short of the optimistic consensus, the market impact could be significant.

Brief fears of a second wave of inflation earlier in the year have largely passed, with few mainstream forecasters placing much weight on this possibility now. There seems little doubt that inflation is easing towards central bank targets, albeit not as far or as fast as earlier forecasts: stubborn pockets of sticky inflation, particularly in services, are lingering and creating uncertainty and bouts of market volatility. It’s painfully slow progress, but core inflation is still trending lower and lead indicators suggest continued normalisation towards more comfortable levels. Of course, that does nothing to reverse the step-change in prices during the inflation surge - it just means that prices rise more modestly from current levels.

In some cycles, interest rate cuts are an emergency response to recession or some kind of crisis; in this cycle, many central banks have already embarked on cuts, without that justification. As inflation trends lower, central banks should be stabilising real rates: 5% interest rates are far more restrictive when inflation is at 2.5% than when inflation was at 4%, so it is necessary for banks to cut rates in a disinflationary world, just to maintain the same degree of policy tightening.

A return of inflation towards normal levels - combined with expectations that it will continue to normalise - has been enough for central banks in the Eurozone, Switzerland, Sweden, much of central and eastern Europe, and several key emerging markets, to begin rate cutting cycles. Markets were excessively optimistic about US and UK rate cuts at the start of 2024; this swung to excessive pessimism and brief consideration of the odds of another rate hike in the spring, after a month or two of poor inflation data, but markets are now pricing in a more reasonable middle ground, with the way likely open to interest rate cuts in the second half of 2024 from both the Bank of England and the Federal Reserve.

If a rare and precious economic soft-landing is indeed achieved, the rate cut cycle could be slow and drawn out: a series of small and gradual rate cuts over an extended period could come to be seen as a powerfully benign outcome for markets. Some doubt that the Fed would cut rates in the face of an exuberant stock market trading at all-time highs; but there’s no reason why not: this has happened 20 times since 1980, and, the stock market stood higher 12 months later every single time. Once the first rate cut is delivered, we can expect speculation to shift over how far rate cuts can go, and where the end of the rate cutting cycle will take us too. Markets are typically quite poor at predicting the extent of such cycles, but the process could at least be more helpful for bonds, and encourage investors who have sheltered in cash to start taking a little more duration risk.

Bonds suffered in the first four months of 2024, as the previous optimism over rate cuts was priced out of the market, but the stabilisation of expectations underpinned better returns since late April. Over the quarter, global aggregate bonds eked out a marginal positive return, and have now delivered a return of around 4% over the past twelve months: perhaps an acceptable return for a defensive asset, held alongside equities in portfolios to add diversification and potentially smooth out returns in periods of stockmarket volatility. Corporate bonds, especially the debt of riskier borrowers, have outperformed. The last few years have seen a dramatic repricing of bonds: index-linked gilts and longer-dated Treasuries have lost a quarter to a third of their value: but that repricing offers opportunity. With the global aggregate bond index now offering a yield to maturity of over 5%, investors see a meaningful role for bonds in portfolio construction. Riskier corporate bonds yielding 7-8%, emerging market bonds yielding around 7%, and inflation-protected Treasuries offering 2% real yield all outperformed broader bond markets so far this year, and offer investors a broad toolkit for diversification. However, some wariness is needed: credit spreads - the additional income available for lending to riskier borrowers - are narrow, and certainly not pricing in recession. If growth takes a turn for the worse, riskier bonds in particular could be vulnerable to a repricing of credit risk.

Markets should have long since priced in a change of UK government, with the polls pointing to a significant Labour win for many months: Sterling has traded in a very tight range for the first half of the year, suggesting that markets have already digested the outcome. Over the balance of the year, we may yet see major change in the White House and in the French legislature. All these changes may have far-reaching social and political implications, but we should be wary of how we read across to financial markets. Fears over reigniting inflation, combined with unusually high levels of government debt relative to GDP mean that - whatever the initial market reaction, and whatever their instincts - governments will face significant constraints on new spending plans. But a risk lingers behind some government bond markets, even if inflation continues to moderate: modern right-wing populists tend to spend more freely than traditional conservatives - if populists make gains in the US, France and elsewhere this year, with promises of spending despite existing high levels of debt, concerns over worsening deficits and the sustainability of government debt trends could flare up.

Equities have made stunning progress in 2024: last year was a good vintage for stocks and 2024 has generally offered more of the same. Global stocks have gained 12% YTD, led by Japan, India and the US - with US large cap growth stocks leading the way, up over 20% YTD. Stocks elsewhere have made gains: stocks in the UK and several European countries even made new all-time highs - but with more modest advances, up 8-9% YTD, although French equities were a drag on Eurozone stock indices, with markets reacting negatively to the prospect of the far-right gaining in parliamentary elections.

Some commentators fear that an equity bubble is inflating, that exuberance has run too far; many worry that the narrow segment of stocks driving the outsized market return leaves markets vulnerable: the ten largest stocks have contributed over 70% of the US equity market return so far this year, and only two sectors (IT and Communications) have beaten the global market benchmark. The flipside of this of course is that valuations remain much more appealing in segments of the market that are not being driven by the current technology-related euphoria.

A voice of caution amid the equity market surge: in the long-term, valuation matters - “yield is destiny”. This points to reasonable long-term expectations for bonds, albeit with less reward than usual for taking duration or credit risk relative to shorter-term bonds. On the other hand, valuations in the equity market are at levels where investors might expect long-term returns for the market as a whole to be below average. Valuation tells us next to nothing about likely market returns in the next few quarters, but it could have more predictive power on a long-term view. Diversification away from equities - especially away from large-cap US equities - has been a headwind for investors over much of the last 15 years. But extremes of valuation today suggest that a more diverse portfolio, including both cheaper equity investments (smaller companies, non-US stocks) and allocations to less expensive asset classes (particularly in fixed income) could have the longer-term odds in its favour, and help to navigate through the inevitable periods of volatility.

Investors may be concerned by weakness in some cyclical commodity prices: not just lumber, down 25% since March, but also copper, down 10% since peaking in early May. Broader commodity indices have been supported by oil and refined products, where prices have pushed modestly higher since the start of the year, and by Gold, which touched a new all-time high above $2400/oz in late May. The Dollar has maintained its modest strengthening through the second quarter, gaining about 1% against its trading partners, as markets priced in US interest rates staying higher for longer than most others. The Japanese Yen continued to weaken, reaching its lowest level against the Dollar since 1990. A weak Yen is potentially positive for Japanese companies, but overseas investors riding the surge in Japanese equity markets this year will have seen large stock price gains offset by big currency losses, unless they had hedged their exposure to the Yen.

There are undoubtedly signs of complacency in markets: index volatility has been very low as markets have made stately progress higher, with over 300 trading days passing since the last 2% down day for US equities, an unusually long sequence of low volatility; and surveys indicate that investors are holding unusually low cash allocations.

Overall, we see growth is slowing, and inflation is not normalising as fast as investors would like. Meanwhile stocks have made enormous, though narrowly-based, gains and valuations are demanding. Markets can stay buoyant, while companies keep delivering strong earnings growth, and the economy stays on the narrow path to a soft landing, allowing the Fed to begin a gradual and supportive cycle of rate cuts. That scenario requires a lot to go right: calm and complacent markets can easily shift to volatility if doubts emerge about inflation and the pace of rate cuts, or about growth and the resilience of corporate profits: after an extended period of calm, the scene is set for volatility in face of disappointing news flow. With reasonable yields on offer across fixed income markets, and reasonable valuations across many stock market assets outside the US, the case for a robust, diversified portfolio is as strong as ever.

N.b. All content is based on data at the time of writing on 5th July 2024.