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US economic and inflation data are validating our view that a soft landing for the economy is increasingly likely.

Solid reports on everything from the labor market to durable goods orders in the US have mitigated fears that central bank tightening to date will spark an imminent recession. And recent inflation figures have reduced the odds that central banks will need to deliver ever-tighter monetary policy in order to cool price pressures.Ìý

But as a soft landing has become more probable, this good news has also been more priced in to financial markets. We view the increasing popularity of positions associated with more benign economic outcomes, softness in global activity outside the US, and the potential for renewed stickiness in inflationary pressures as three of the key challenges to the soft landing thesis. While we are closely monitoring these risks, in our view, these threats to the expansion and market rally are likely to be overcome. Positioning for a soft landing still appears to be an attractive risk-reward proposition.

We continue to be overweight global equities, and prefer exposures more levered to US economic strength. These include the S&P 500 equal-weight index, US mid-caps, and cyclicals over defensives.

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Investor sentiment and some measures of positioning have normalized substantially after being depressed for a prolonged period. As such, risk assets have grown more susceptible to any incremental news that violates the soft landing thesis.

There is no denying that US stocks, particularly at the aggregate level, are expensive on an outright basis and relative to bonds. This is one reason why we believe that government bonds continue to warrant a place in portfolios, thanks to their diversifying properties in the event of an economic slowdown and their attractive yields. But while stocks are expensive at the index level, there is a large disparity between a select group of mega-cap tech stocks and the vast majority of US large and mid-caps – our preferred exposures – which are more fairly priced.

This combination of high valuations and normalized positioning must be balanced against the market and macro fundamentals, which we believe are still strong. Earnings are surprising to the upside by a healthy amount this year after more modest outperformance vs. expectations for most of 2022. Twelve-month forward earnings-per-share estimates are increasing – nearing their record highs from mid-2022. When profit expectations are rising over a three-, six-, or twelve-month period, global equities have a strong positive hit rate. The return of positive real income growth, which in turn is boosting consumer confidence, increases our conviction that the bottom-line outlook for corporates will continue to improve.

Exhibit 1:ÌýInstitutional investor net long positions in US equity futures, individual investor sentiment normalizing

Compared to the US, other major economic regions are not performing as well relative to expectations.

Global industrial production has moved sideways in volume terms for over a year, with a shift in consumption from goods to services and elevated energy costs serving as a drag on activity. Europe’s economy is more exposed to the manufacturing sector, and also more sensitive to higher interest rates since bank loans account for a higher share of corporate financing.

Traditionally, more cyclical industries have been leading indicators for where the rest of the economy is going – and if this were to hold true, weakness in the factory sector globally would be expected to bleed through into other parts of the economy – and eventually weigh on the US, as well.

Yet this has been anything but a normal economic cycle. Pandemic-related shifts in goods and services demand have disrupted the typical leading properties of manufacturing to services. Rather than weakness in the goods sector bleeding into services, we think solid real income growth should allow for an inventory replenishment cycle and pickup in goods spending. Indeed, we see tentative signals of a bottoming in the sector in the internals of manufacturing purchasing managers’ indexes.ÌýThe Citigroup Economic Surprise Index, which measures data relative to economist expectations, shows the US surprising to the upside, but not China or Europe.

Exhibit 2: US economy surprising to the upside unlike, Europe, China

Exhibit 3: Improving internals for manufacturing survey data

We doubt that in the near term the monthly US inflation prints will be quite as low as the June CPI report, where declines in select volatile categories helped contribute to an especially subdued print. And looking ahead to the fourth quarter, we are also wary that some of the seasonal factors currently suppressing core CPI inflation are likely to reverse and boost price pressures.

However, we do believe that upcoming reports will be sufficiently soft to confirm that monthly CPI inflation has downshifted to closer to 0.2% than 0.4%, which had been average for 2023 through May. The slowdown in nominal spending growth and continued deceleration in shelter price growth will be the dominant forces that allow for a continued improvement in inflation outcomes through at least year-end, in our view.

That said, the recent upturn in commodity prices, particularly oil, and potential for a pickup in global industrial activity threaten to increase the stickiness of above-target inflation beyond the very near term. This is not just for headline price pressures, which include energy, but also elements of core inflation like airfares, food services, and other parts of core goods in which fuel prices are a key input.

In our view, any difficulties in getting inflation the ’last mile’ back to the Federal Reserve’s target may constrain how many rate cuts the central bank can deliver in 2024. But it would also likely be associated with enduring resilience in activity – the kind of backdrop in which little monetary policy easing is required to keep the expansion on track and corporate profits moving higher.

Although we continue to scrutinize risks to a soft landing materializing, we still have conviction that core inflationary pressures will moderate while growth remains resilient over the tactical investing horizon.

We believe the best way to express this macro view is through overweight positions in equities, rather than bonds. In particular, we favor more cyclical parts of the US equity market. We retain a neutral weighting toward government bonds, which play an important role in diversifying our more risk-on, procyclical positions. The outlook for growth is still solid, however, which limits how much bond yields can fall, even as inflation moves lower.