Weaker factory activity validates soft landing

US Treasuries rallied on Monday as further contraction in US factory activity reinforced expectations that the Federal Reserve is on track to cut interest rates this year. The yield on the 10-year US Treasury fell 11 basis points to a two-week low of 4.40%, and a gauge of the US dollar was 0.5% lower. The S&P 500 rose a slight 0.1% as some worried the weaker data may suggest that growth is faltering.

The headline ISM manufacturing index dropped to 48.7 in May, from 49.2 in April and below market consensus of 49.5, with both the new orders and production components falling. This is in line with our expectation of a gradual slowdown in US economic growth, which should put the Fed in a position to start policy easing later this year amid falling inflation.

As investors await fresh employment and services activity data this week, which could give more clues on the state of the US economy, we continue to see a supportive macro environment for both bonds and stocks, and believe that the US dollar's strength could top out into the third quarter of this year.

Bonds offer an attractive risk-reward proposition. The latest inflation numbers for April, including the release of the personal consumption expenditures index on Friday, have eased concerns that the disinflation process is stalling. We believe the next move from the Fed will be to lower rates, as we are already seeing in parts of Europe. This is a favorable backdrop for duration risk. Since the outright level of rates is high, we see an attractive asymmetric absolute return profile in light of the current inflation and growth mix. We continue to favor quality bonds tactically, and see value in selective exposure to riskier credits to improve overall portfolio yields.

Stocks have room to advance amid resilient growth. While the US economy is slowing, we don’t see evidence that suggests a hard landing. This means the outlook for equities is positive, with rate cuts providing a tailwind amid solid earnings and secular growth led by generative artificial intelligence (AI). In our base case, we see the S&P 500 reaching 5,500 by year-end, and we continue to like the US IT sector. We also see value in small-cap stocks as the easing cycle begins, as well as diversification opportunities in UK equities on accelerating growth and recovering earnings.

The turn in monetary policies creates opportunities in currencies. While the US dollar could find renewed support in the short term as the European Central Bank and the Bank of England are expected to lower rates before the Fed, we believe any gains will remain within the ranges seen earlier this year as the greenback is already richly valued. Repricing the dollar meaningfully higher due to higher US yields would require larger interest rate shifts, and a Fed hike remains an unlikely outcome. This should allow USD investors to engage in volatility-selling strategies to pick up additional yield and reduce USD exposure ahead of Fed cuts. We continue to favor the Australian dollar as the Reserve Bank of Australia is unlikely to move until at least early 2025.

So, we see a range of opportunities for investors to earn returns in today’s markets, and view this as a constructive environment across asset classes.