The Turning Point at Last?

Quietly but steadily, the US economy has finally slowed by most measures, and the Federal Reserve’s first interest rate cut since 2020 is now widely expected in September.

After a year filled with revisions to rate-cut forecasts, will the Fed’s first move be anticlimactic? On the contrary, as Lazard’s fixed income teams discussed at their monthly meeting recently. If the Fed lowers the policy rate in September, up to two more cuts are likely before the end of this year, in their view. And despite the uncertainty stemming from recent and upcoming elections, Fed easing may trigger a change in the long-standing pattern of investment flows into US assets, affecting bond and currency markets globally.

US: A Soft Patch

With the memory still fresh of higher-than-expected US growth and inflation in the first quarter, the softening in the US economy may seem sudden, but in fact, most economic data has been softer since then.

One stand-out to Lazard’s analysts was the most recent labor market report. The uptick in the unemployment rate in June to 4.1% from 4.0% garnered the headlines, but under the hood, the data also showed slowing wage growth, weak manufacturing payroll figures, and a significant downward revision to job gains in May, our analysts noted. Also noteworthy to our US team: The ISM Services Index unexpectedly fell below 50 into “contraction” territory in June, as did services new orders, a more forward-looking measure.¹

Importantly, the slowdown has been reflected in a steady decline in inflation since April, culminating in a headline annual Consumer Price Index (CPI) of 2.97% for June—the lowest level in more than three years.² Even more convincing to our team, the CPI run rate in the second quarter fell to 1.05% for headline CPI and 2.1% for core CPI (which excludes food and energy), a sharp reduction from the first-quarter pace.

The slowdown has been modest, however, and is not likely to morph into a recession, in the view of our bond experts. The significant public fiscal deficit implies a private surplus. Indeed, household balance sheets overall have been healthy, albeit with a rise in loan delinquencies as the economy softens, and corporate earnings for the S&P 500 are expected to grow 9% this quarter, according to Lazard’s global market strategist. Putting it all together, US growth could slip to either side of 2% from 2.5%–3% currently, in our strategist’s view.

Nevertheless, the soft patch does open the door to a Fed easing cycle starting in September, according to our US team—a view now shared by the bond market. Our analysts currently expect two or three cuts by year-end, though the cycle overall could be shallow, in their view: Judging by the recent data, the US economy no longer needs to be restrained, but it also doesn’t seem to need the boost that a long round of rate cuts would bring.

Expectations for Fed rate cuts were clearly reflected in bond yields. The two-year Treasury yield—historically one of the best indicators of where Fed policy is headed—dropped to 4.45% by mid-July from 5% in April. The 10-year yield also fell more than 50 bps in that time to 4.18%. Of note to the US team, the record-long inversion of the US yield curve, which began exactly two years ago, eased over the past month from -50 basis points (bps) between two- and 10-year yields to less than 30.³

Our portfolio managers have felt confident about the direction of rates, inflation, and the yield curve for a long while, but the softening of the US economy has brought some welcome clarity on timing. They now believe that the yield curve will steepen further in the second half of this year, historically tight credit spreads will loosen eventually as the economy slows, and agency mortgage-backed securities—which they have overweighted—should benefit from a more certain rate environment.

With such a sanguine outlook, what are the risks? It is possible that the Fed has waited too long to cut rates, which could lead to a sharper slowdown than our analysts expect. In that case, the government’s appetite for any “bailout” spending could be limited by the high budget deficit of 7% of GDP;⁴ the deficit is also likely to keep Treasury bond issuance quite high, the US team pointed out. Another cloud on the horizon is the uncertainty over the US election—including the potential for tariffs of 60% on imports from China and 10% on other countries if former President Donald Trump is elected. Tariffs can lead to inflation, but more concerning to our team was the potential impact on US companies’ profit margins if they cannot pass along the higher costs to customers.

Emerging Markets: On the Cusp?

As the target countries of any potential US tariffs, emerging markets were very attuned to the US election, but it was only one of several uncertainties that have left local currency bonds without clear direction this year, according to our specialists. The chief market driver of late has been the risk of fiscal expansion in some countries after surprise election outcomes recently, notably in Mexico, they added.

Another concern has hung over emerging markets for much longer, according to our analysts: the static state of investment flows. Higher-for-longer interest rates, strong growth, and a rising stock market in the United States have attracted massive international fund flows and made the dollar exceptionally strong—to the detriment of emerging markets bonds and currencies, in their view.

Fed easing, then, would be a very welcome development. Once an actual rate cut occurs, the team believes the US dollar will fall significantly. At that point, emerging markets should be well positioned to compete, in their view: Economic growth has been stronger than expected at 4.5% over the first half of 2024; inflation is projected to average 3.5% for this year, far below its peak in 2022; fundamentals in the private sector remain very strong in certain countries, notably Brazil despite recent sell-offs; and valuations have been deeply discounted versus those in developed markets. US rate cuts should also allow emerging markets central banks to ease without incurring too much pressure on their own currencies and assets, our analysts pointed out.

Until the first Fed rate cut, however, they expected local currency emerging markets bonds to remain unsettled.

Emerging Markets Corporates

In contrast, hard currency corporate bonds have been a bright spot, returning 4.2% for the first six months of this year. That compares with -2% for local currency bonds and 3% for hard currency sovereign bonds, based on JP Morgan’s emerging markets bond indices.⁵

What has driven performance in corporate bonds? First and foremost is yield, according to our emerging markets specialists; yield has provided both attractive carry and room to absorb some rate or spread moves. Second, the relatively short average duration of 4.2 years has meant less adverse impact from the move higher in US yields compared with longer durations. Lastly, spreads have compressed, partially offsetting the move higher in rates.

While spread compression has also made corporate bonds less compelling for investors than they were at the start of the year, our analysts noted, spreads have still been wider than similarly rated developed market credit, and fundamental risks seemed low to our team, given strong corporate balance sheets.

Leverage for the sector overall has declined from 2.9x a few years ago to 1.5x currently, the lowest in the past 10 years and lower than the 2.6x for US corporates on average, according to Bank of America analysis. Consequently, even if global or local growth slows, there is room to absorb a moderate earnings decline while keeping leverage manageable, in our team’s view.

While some companies could be challenged by slower global growth and de-globalization, our team saw opportunity in countries with endogenous growth opportunities, such as India, and in countries that seem to be exiting periods of stress, possibly into a positive structural improvement, such as Turkey and Argentina. They have also watched for opportunities in volatility and market “overshoots” stemming from elections, rates, and headlines.

Europe: Hot and Cold

Political uncertainty has reached a fevered pitch in Europe with the surprising outcome of second-round French elections on 7 July.

Coming from behind, the far-left New Popular Front took first place, winning 31% of the seats in Parliament, while President Emmanuel Macron’s centrist alliance attained 28%, and the far-right National Rally—which was expected to win—came in third with 25%. After the initial reaction of surprise and relief among supporters of the left-wing and centrist parties at defeating the far right, gridlock set in; without a majority, France was left without a functioning government.

Reaction in the country’s bond market mirrored the election result: paralysis. Government bonds, Obligations assimilables du Trésor or OATs, sat at 65 bps above German bunds as of mid-July. In some ways, our European analysts pointed out, the stasis was not a bad thing since it meant that investors were not anticipating a negative outcome. However, spreads had jumped to as high as 81 bps during the elections, as the exhibit shows, and our analysts expect more bouts of volatility as the top three political parties struggle to find a way forward.

Conditions in the region appeared cooler otherwise. A stream of softer economic reports flowed from Europe after several months of what appeared to be a recovery.

To Lazard’s European bond specialists, the disappointing news on the economy was not surprising, and they expected to see more of the same—despite more optimistic forecasts from the European Central Bank (ECB) and others for around 1% growth by year-end, up from 0.3% in the first quarter.⁶ The reason? In our team’s view, it comes down to the fact that Europe did not engage in the same level of fiscal stimulus as the United States did during and after the pandemic. As a result, while the United States has been posting higher-than-expected growth until recently, Europe’s economy has been generally flat. Now, with political paralysis and a deficit that exceeds the European Union’s limit in France and a debt brake in effect in Germany designed to enforce fiscal discipline, our analysts believe that growth is unlikely to get much further off the ground.

The silver lining perhaps is that the list of countries cutting rates has been expanding. The Bank of England appeared to be on the brink of easing, our European team noted, while the ECB as well as central banks in Switzerland and Sweden have begun.

Competing Headlines

Until recently, speculation over Fed rate cuts has dominated the fixed income markets. Now, as easing appears imminent, the Fed will likely share the headlines with political uncertainties and policy concerns. Nevertheless, the Fed’s first rate cut is nothing to scroll past: In the view of our fixed income team, it will be as significant as ever for investors around the world.