In the last 12 months, financial conditions have tightened to an unprecedented degree, including a rise in the Fed Funds rate from 1% to 5%. But the lack of damage to the financial system is surprising with the total sum of financial failures limited to just one large Swiss bank, one medium-sized American bank and a few small banks.
While other regions struggled, the S&P 500 index posted solid gains in the first half of the year. It should be noted, however, that concentration levels in the index are at their highest since the 1970s, with seven of the largest constituents (Apple, Microsoft, Google, Alphabet, Amazon, Nvidia, Tesla and Meta) rising sharply while the other 493 stocks in the index remained largely unchanged. History shows that overvaluation and speculative behaviour are usually the cause when only a few stocks do well.
In terms of growth, the fundamental question is whether the US economy is heading for a recession that will impact corporate profits, or a softer landing whereby the Fed manages to keep inflation in check without adversely affecting the economy in the process. It is possible that this scenario could occur, and we have adjusted the probability of such a scenario upwards, to reflect the remarkable resilience of key sectors such as the labour market.
However, we must remember that recessions in the past have usually followed aggressive Fed tightening, with a downward shift in market prices and positioning. An important factor is the accumulation of excess savings. Pandemic relief programmes and curbs on consumer spending have driven excess savings to record levels but most of this surplus has already been used up and if recent spending patterns continue, the rest is likely to diminish by the end of 2023. Once this surplus is depleted, budgets will need to rely on organic
sources in the future. This is feasible as long as the labour market remains stable, but if it destabilises, we will face significant challenges.
To sum up, financial markets are taking a leap of faith around growth and inflation. Our portfolios are positioned so that they deliver even in the absence of a soft landing, which makes us cautious. Therefore, given the strong start to the year and the risk of risinginterest rates, we have reduced risk and remain underweight equities and overweight bonds.
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