Key points:

• Markets were jolted by the sharp back-up in yields, leading to the biggest correction in equities in months
• We do not expect this move higher in yields to be sustained and believe the bulk of the move is done
• We also expect risk assets to continue to grind higher following a healthy correction, and maintain our exposure, while continue to add diversifying strategies

Macroeconomic overview

• As demonstrated by the recent jump in yields, US growth expectations are robust, even though, just a few weeks ago, questions started about when the next recession might occur. While we expect growth to slow into end of 2019 and 2020 as the fiscal stimulus fades, a recession might not come until even later. Indeed, PMI manufacturing data was softer, but still very strong, as were services. There is some concern over medium-term impact of trade and we are seeing businesses react, although it is not yet reflected in the data. Overall, while the synchronized global expansion is over, global growth remains solid.

• Fed Chairman Powell may have been the trigger for the back-up in yields as he was more hawkish in recent remarks highlighting that the Fed could go past the ‘neutral’ level. Since then, while non-farm payrolls were good, wages aren’t rising much faster and inflation was a little softer than expected as well. We do not expect this move higher to be sustained, and already yields have retreated somewhat from recent peaks.

• Italian budget negotiations are ongoing, as Italians don’t want to bring their 2019 budget plans down, maintaining confrontation with EU policymakers. Spreads are back close to August highs, and banks are under pressure again, showing investors aren’t pleased by the proposed plan.

• Brexit negotiations are moving along, with the possibility of a deal looming closer. Both sides could come to an agreement on temporarily remaining in customs union and on Northern Ireland, sparking some optimism.

• Jair Bolsonaro won 46% of the vote in the first round of the Brazilian elections – not enough to secure outright victory, but he is favorite to win the run-off on October 28th. He is seen as the most marketfriendly candidate, and markets were happy with the result.

• While we have had further good news on trade between the US & Canada, who came to an agreement for a new NAFTA deal – now names USMCA, trade tensions between the US & China are unlikely to abate anytime soon, as Chinese policymakers have said they would remain strong and not cede, and President Trump happy to have this narrative into the midterm elections,

• The US dollar advanced on higher rates, although much of the hiking path was already priced in, and we do not expected a sustained trend higher, but broad range-trading.

Market outlook

• This week’s sharp sell-off in equity markets was most likely triggered by fears of quickly-rising rates, as in February – speed & scale are more important than levels. Indeed, US macroeconomic data is pointing to ongoing strong growth, wages seem to be rising, and Fed Chairman Powell was more hawkish than expected, leading to a sharp back-up in yields. In our view, this is an interesting move, as up until recently, fears were around when the next recession would come, and when the yield curve might invert. While we do expect US growth to slow somewhat into the end of 2019 and 2020 as the fiscal stimulus fades, an actual recession might not come until even later.

• Equity markets don’t like sudden moves, so a 20bp rise in yields within a couple of days will create a reaction, often even an overreaction. Moreover, we think markets had probably been looking for an excuse to take a breather, as trade wars had been relatively well absorbed by markets, and a sharp move in rates was an easy trigger. We expect markets to resume their grind higher in the coming months, even if this correction continues in the coming days. Fundamentals remain robust – US growth, corporate profitability, shareholder friendly activity – which should underpin markets to some extent. We could start to see questions about earnings expectations, as current levels are not sustainable, and, starting with this Q3 season, we should see ongoing downward guidance. How markets digest this transition could lead to further volatility.

• We appear to have moved from a world worried about the yield curve inverting, and when the next recession might occur, to a world worried about higher rates in just a few weeks. However, fundamentals haven’t changed much, we therefore do not expect a much bigger move from here in terms of yields, and they could even retreat into the end of the year. Indeed, inflation data also came in softer than anticipated, so we do not expect rates to back up significantly from here. We continue to look for more flexible, absolute return strategies, but, for those less worried about duration at current levels, adding more core strategies as protection could become interesting.

• Credit markets handled the latest sell-off relatively well, with some widening in US HY (from very tight levels) and almost no reaction from IG. Even EM corporate spreads have proven resilient. Overall, we continue to see any increase in volatility as opportunities in a still-expensive market.

• This week is a great example of the complex investment environment we are navigating, which comforts us in our portfolio diversification allocations, such as shorter duration, yield enhancing strategies, absolute return flexible strategies and alternatives. We expect risk assets to continue to grind higher, and maintain our exposure. It might not be time to add too much risk, but we don’t think it’s time to take it all off either.