How different asset classes performed in the first half of the year and what we should expect next.
The market was in a state of anticipation last week, with the release of critical US inflation data on Friday afternoon (which came in as expected), the first round of French elections later this week and the end of the first half of the year.
Over the week, we saw signs that things may not be as stable as asset prices suggest. Inflation in Canada1 and in Australia2 accelerated in May. In the latter country, inflation rose from 3.4% at the start of the year to 4% in May: unless there is a sudden loss of price momentum, the Reserve Bank of Australia could be forced to raise its key interest rates at its next monetary policy meeting in August.
On the economic activity front, the closely watched Ifo index of German business confidence unexpectedly fell from 89.3 points in May to 88.6 points in June, with both the current component and the outlook weakening.3. This could be a sign that the gradual recovery of Europe’s largest economy is facing headwinds. Similarly, in the United States, a series of weak housing data and a downside surprise in durable goods orders4 are all evidence that the Federal Reserve’s restrictive interest rate policy continues to affect entire sections of the economy.
Debt and depreciation
This week, it was the International Monetary Fund’s turn to warn the United States of the dangers of unlimited government spending, declaring that its “budget deficit is too large, creating a sustained upward trajectory for the public debt-to-GDP ratio.”5.
Earlier this month, the Congressional Budget Office raised its estimate for the current fiscal year’s budget deficit by 27% to $1.9 trillion, or 6.7% of GDP, from its February forecast of 5.3%.6.
Meanwhile, in Japan, pressure on the yen resumed, closing the week above the psychological level of 160 against the US dollar, with Finance Minister Shunichi Suzuki again expressing his displeasure at the continued weakness.7. If a currency is the clearest reflection of an economy’s health, what we’re seeing with the yen could suggest trouble for Japan. The yen is the weakest of the major currencies so far this year (see chart of the week).
Reflections on the first semester
As the first half of the year draws to a close, what’s coming out from an investment perspective?
Most 10-year government bond yields rose, with the notable exceptions of China and Switzerland, both of which cut their policy rates over the period. Most government bond curves rose in tandem, with the exception of the UK and Japan, whose curves steepened. French debt was the worst performer among the G10 countries, perhaps a warning to other nations about the need to maintain fiscal discipline and political stability.
In credit, high yield outperformed investment grade as higher-for-long interest rates and soft-landing scenarios took precedence.
The unloved emerging markets sub-asset class – at least in terms of investor flows – outperformed in both the investment grade and high yield categories. Emerging markets high yield ended the first half of the year 3% ahead of its U.S. counterpart, with returns broadly spread by geography and sector. While Latin America was the largest contributor to the index in total returns, Asia took the top spot in efficiency per unit invested.
Such a pattern is typically observed once the default cycle has peaked. The eurozone corporate universe is relatively clean, in our view, with weak companies defaulting and exiting the index, leaving behind a stronger cohort. Bond prices for the distressed credits that remain in the index could recover as investors realize that the probability of default has been overstated. This can happen when domestic conditions improve, thanks to policy easing and a recovery in growth and profits, which we are seeing in emerging markets.
Developed markets outperformed emerging markets, led by the seven major U.S. technology stocks, which gained 38% in the first half of the year. In Latin America, Brazilian and Mexican stock markets fell more than 15% in U.S. dollar terms. This may be a warning to the new governments in both countries against pursuing a socialist agenda.
The US dollar rose against most major currencies on the Fed’s decision to stay on the upside longer, while commodities benefited from the soft landing and supply constraints that pushed up energy prices and allowed metals such as copper, zinc and gold to rise more than 10%.
With healthy returns across all markets, from credit to equities to commodities, it may come as a surprise that assets held in money market funds (MMFs) remain elevated after record inflows in 2023. In fact, at the end of the first half of the year, assets in U.S. money market funds stood at $6.1 trillion, slightly higher than at the start of the year.8.
This brings us to the vexing question: Could the unwinding of money market funds be the major event of the second half of the year?
Chart of the Week: Japan’s Imbalances Reflected in Its Currency
Source: Bloomberg, as of June 28, 2024. For illustrative purposes only.
1Bank of Canada, as of June 25, 2024.
2Reserve Bank of Australia, as of June 26, 2024.
3Ifo Institute, as of June 24, 2024.
4United States Census Bureau, as of June 27, 2024.
5International Monetary Fund, as of June 27, 2024.
6Congressional Budget Office, as of June 18, 2024.
7Reuters, ‘Japan issues fresh warnings against sharp yen falls,’ as of June 27, 2024.
8Investment Company Institute, as of June 27, 2024.
