How soft is a soft landing?

It was a brief shock at the beginning of August: partly due to a disappointing jobs report, investors started to fear that the US economy was moving towards a recession. The fear, however, was short-lived. Soon, investors regained confidence that the US is heading for a soft landing. In that scenario, inflation and growth decline without the economy falling into a recession.

Disappointing macro data, such as the job figures that caught investors off-guard last month, fit the picture of an economy that is cooling down a bit. Indeed, a soft landing can feel a little wobbly. As for the US economy, such a soft landing remains our base scenario. We expect somewhat slower growth in the US during the third and fourth quarters of this year – but no recession. The US economy remains resilient, even though the risk of a recession has slightly increased.

The eurozone economy is recovering gradually. The European services sector is growing significantly, while the production side of the economy is somewhat disappointing. All in all, we expect the recovery to continue in the coming months, albeit at a modest pace. We also think that growth will remain below trend level for the remainder of 2024.

Recent data showed that economic activity in China slowed more sharply than expected in August. Retail sales fell more than estimated on a year-on-year basis. And a further decline in house prices underscored that China continues to face headwinds from its troubled real estate sector. We now expect the Chinese economy to grow by 4.9% in 2024, compared to our earlier forecast of 5.1%.

Overall, we believe the world economy is gradually heading towards more trend-like growth. And inflation is decreasing, enabling central banks to support the economy by lowering interest rates. Against this background, we maintain our slight overweight in both equities and bonds. However, we are making a few changes to our equity sector positioning. Additionally, we choose to invest more in quality bonds at the expense of riskier bonds.

After the brief market turmoil in August, equity markets rebounded – with the US leading the way. US consumers continue to spend, which supports corporate profit growth. Declining interest rates provide a further tailwind for equities. With ample room to cut rates, it can be argued that the so-called ‘Fed put’ has returned. (The ‘Fed put’ is an analogy derived from the options market; it refers to the Federal Reserve’s readiness to support markets if necessary.)

Stocks are not cheap, although we see significant regional differences. US stocks are relatively expensive, while valuations in Europe and emerging markets are around their average levels. Given the modest but positive economic growth we expect, we still find a slight overweight in equities justified.

Although our economic expectations remain positive, the economy is clearly slowing down. Therefore, we are choosing to invest less cyclically at the sector level (cyclical sectors are sensitive to economic developments). First, we suggest that investors reduce their position in the industrial sector from slightly overweight to neutral. Our second suggestion is to lower the weighting of the materials sector from neutral to slightly underweight. Companies in these two sectors may face declining demand, especially now that growth in China is slower than previously expected.

At the same time, we are choosing to invest more in healthcare. We suggest that investors increase their position in healthcare from neutral to slightly overweight. Not only is this sector less sensitive to economic developments, but healthcare companies also benefit from long-term demographic trends, such as an aging population.

The information technology (IT) sector benefits from long-term trends as well. Digitalisation continues. And the rise of generative AI is expected to remain a driving force for many IT companies. Earlier this year, we reduced our overweight position in IT to neutral, as the sector’s valuation seemed stretched. In early August, IT stocks were among the hardest hit during the market sell-off. As a result, valuations of these stocks have decreased somewhat. We therefore see this as a good time to increase the weighting of IT again, from neutral to slightly overweight.

We maintain our neutral positioning in all other sectors – with the exception of consumer staples, where we continue to be slightly underweight. At the regional level, we maintain our preference for the US over Europe. We remain neutral on emerging markets.

The European Central Bank started lowering interest rates in June. Last week, the US Federal Reserve also began a rate-cutting cycle: the Fed cut rates by 0.5%. Lower interest rates are generally good news for bonds: when bond yields fall, prices rise. We therefore remain slightly overweight in this asset class.

However, we believe that risk premiums (spreads) on risky bonds have little room to tighten further. By risky bonds, we mean bonds that carry relatively high credit risk, such as high yield and emerging market debt. If the economic situation were to deteriorate, spreads on these bonds could rise (causing prices to fall). Yields on high-quality bonds, such as government bonds, are only marginally lower than those on risky bonds. But these quality bonds are better suited to withstand potential adverse conditions.

In this light, we find it justified to take some credit risk off the table. We therefore suggest that investors reduce their position in emerging market debt. Proceeds can be used to buy safer European government bonds and investment-grade corporate bonds.

In recent months, we have seen volatility in financial markets flaring up at times. In the coming months, more volatility is to be expected in the run-up to the US presidential elections. Investors will also remain wary of economic setbacks, now that the economy’s landing is underway. That trajectory can feel a bit bumpy here and there. But – returning to the aviation metaphor – if we look out the imaginary airplane window, the weather conditions seem friendly enough to make a soft landing feasible.

Richard de Groot
Chair ABN AMRO Global Investment Committee