Price stability gives way to full employment

Inflation appears to be under control, entering the Federal Reserve's target range last month. With the economic momentum slowing, the central bank focus shifts to its second mandate: supporting full employment.

The start of August was anything but promising. An unexpectedly weak US jobs report triggered a sell-off in international markets. The message was clear: restrictive monetary policy of recent years is taking effect, albeit with a delay. As a result, markets called for swift action from the Federal Reserve. While one to two rate cuts in November and December this year were considered appropriate as of July, a single labor market data print suddenly led to expectations of five rate cuts in the remaining three meetings of this year.

This caused significant disruption across interest rate markets. In the USD/JPY carry trade, where investors borrow in a low-yielding currency (JPY) and invest in a higher-yielding currency (USD), a wave of mass liquidations occurred. Consequently, the Japanese stock market experienced its largest sell-off since 1987. Global equity markets quickly lost more than half of their yearly gains, and the previously stable market suddenly appeared very fragile. However, a closer look at volatility revealed that the correction also had technical aspects: while short-term volatility spiked to its highest level since the pandemic, expected volatility over six months only increased slightly, reaching just below the average of the last four years. As a result, the recovery was swift. It took less than 10 trading days for the losses to be recovered, and equity markets have already climbed higher since the beginning of August. For those who don't follow markets closely, the recent turbulence may have gone unnoticed. However, from our perspective, these developments send a clear message. In the May edition of "Sound Invest", our headline was "Bad News is Good News." This was accurate in an environment of high inflation, where central banks were striving to rein in economic momentum. But with the macroeconomic data of recent months, the battle against inflation seems to be nearing its end. As a result, the other part of the central banks' dual mandate - full employment - is likely to take center stage.

This also signals a regime shift: bad news may now indeed be interpreted as such. However, the current data does not reflect an economy that would justify the volatility seen at the beginning of the month. While there are clear signs of a slowdown, this is exactly what central banks intended. There is sufficient evidence to suggest that a soft landing for the economy is a realistic scenario. It now seems that the stage is set for gradual rate cuts in the US as well, which would improve the investment environment. Nonetheless, sensitivity to negative macroeconomic surprises is likely to increase, potentially leading to heightened volatility in the coming weeks.

This environment aligns with our current positioning, which we left unchanged in August. We continue to favor longer maturities for issuers with solid credit ratings and avoid high-yield exposure in the bond market. In the equity space, we believe that expensively valued sectors such as technology and communication are more vulnerable to corrections. Accordingly, on a regional basis, we continue to prefer the Swiss stock market, and in terms of sectors, we focus on consumer staples and energy.