The earnings season has started with the four largest US banks reporting results. The key takeaway from last week is that the US economy remains resilient, the US consumer remains in good shape, loan losses remain in check, and there is no sign of undue stress in the system.

A soft landing of the US economy is the most likely outcome, a statement we can subscribe to as well. For the equity market, this means we can expect a year of solid earnings growth, albeit weighted to the second half of the year.

A modest upside surprise in the latest US inflation print has some market participants wondering what this all means for the path of future Fed rate cuts. We see no reason to change our view. Removing stickier inflation components like housing still shows that inflation is on the right path. The incoming data will remain volatile, so the Fed may be inclined to take its time. However, our baseline scenario of a first cut at the Fed’s May meeting remains unchanged. 

US inflation: Volatility argues against early rate cuts

The US reported higher inflation in December, which makes early rate cuts by the Fed less likely. The modest upside surprise in US inflation can be seen as a reminder that the decline in inflation is entering more turbulent waters. Inflation volatility is not necessarily altering the downtrend of US inflation, but rather creates some uncertainty around the speed of the decline in inflation towards the 2% level that the Fed wants to achieve.

Headline inflation stood at 3.4% and core inflation, which excludes particularly volatile components like food and energy, was reported at 3.9%. The main persistent inflation driver is still the elevated level of housing inflation, while goods prices are stagnating, and food inflation has moderated.

The reported inflation dynamics seem to confirm that the imbalances between demand and supply that pushed inflation higher in 2022 have disappeared for good. At the same time, the inflation uptick shows that some uncertainties remain with regard to the disinflation trend. This volatility supports the recent pushback by Fed officials against markets’ expectations of policy rate cuts beginning already in March 2024.

USD high-yield bonds: Defaults are not going to disappear

As the bond market enters a year that is expected to mark the start of a new cycle in terms of central bank policy direction, i.e. interest rate cuts, investors might wonder if this will also translate into a big relief for leveraged balance sheets and the continued outperformance of the USD high-yield segment.

Historically, the number of credit events does not simply collapse following peak policy rates. Admittedly, historic patterns might be misleading at this point, as the first rate cuts are presumably not arising in a moment of emergency, as was the case more often than not in the past. However, this also means yields with a medium-term tenor, which are more relevant for corporate financing, will most likely continue to reflect the higher cost of capital and not reverse back to financial repression territory. As such, we do not expect defaults to disappear, as weaker companies inevitably face high credit costs for a longer period, offsetting the benefits of the better-than-feared economic backdrop.

What does this mean for investors?

For 2024, we remain constructive on the banking sector, despite the declining interest rate trend and expected interest rate cuts by central banks. For large US banks, we expect some erosion of net interest margins, while regional banks could benefit from a relief of funding costs later into the year.

The outlook of declining rates has improved the likelihood of a soft landing in particular for the US, hence loan losses should remain in check and unrealised bond investment losses are on the decline and therefore support book value growth.

We stick to the strategy we laid out coming into the year. Avoid high-yield bonds as the risk-reward profile is not attractive; stick to quality issuers with longer duration to lock in attractive yields. On the equity side, we still like last year’s winners in the information technology and communications sectors and prefer defensive over cyclical stocks for now.