The artificial intelligence theme ballooned exponentially on markets, so much so that gains by the S&P 500 were due to a handful of stocks likely to benefit from this new craze. He was not expecting China’s recovery to be strong. Chinese equities are still very volatile with zero or negative performance trends, Melman added. On the other hand, the US and Europe have provided confirmation that disinflation has begun – just as he expected – thanks to production chain tensions almost evaporating and steep falls in energy and food prices.  

Disinflation is still shaky but gathering strength
Melman believes that the trend is fragile as disinflation still relies on traditionally volatile commodity prices but falling inflation expectations among households and companies are providing a firmer footing. He thinks that the ongoing slowdown in inflation will probably soon weigh on wage increases but not as much as needed. He sees no indication of a switch to austerity from the lax budgetary stance which has dominated the post Covid/Ukraine war environment; inevitably, this only makes the mission of central banks more complicated. It is, however, interesting to see that greedflation has almost disappeared in the US and is slowing in Europe, so the chances of taming inflation have improved, Melman said.

Paradoxically, the US banking crisis actually stimulated liquidity as commercial banks queued up at the Fed’s emergency discount windows, he added. But now that the debt ceiling has been raised, the US Treasury will have to replenish its coffers by asking for hundreds of billions of dollars from the Fed. This will act as a drain on commercial bank reserves and could trigger weakness in risk assets, he continued.

Valuations are currently at a crossroads
Take the case of a US investor having to choose from three benchmark asset classes, money market funds, investment grade bonds and the S&P 500. All three were offering the same yield in the middle of June, rather as if risk premiums had taken a back seat. Basically, the case for overweighting equities today – when there is still a risk of recession – has to be based on expectations that a growth shock is on the horizon, Melman said. “We could, for example, see the artificial intelligence revolution as a shock (even if the stocks directly concerned by AI are already very expensive). In this scenario, AI is a force capable of generating huge productivity gains across economic sectors,” he continued. 

Since Robert Solow’s famous aphorism, “You can see the computer age everywhere but in the productivity statistics,” new technology has generally failed to generate the hoped-for productivity gains.

According to economist Robert Gordon, the internet revolution did in fact improve US productivity in the decade between 1995 and 2005 but only for that period. Elsewhere, the absence of any lift to productivity in the other developed countries has been puzzling to say the least. 

It could of course be different for artificial intelligence but previous episodes warrant a minimum of caution, he said. In addition, over the shorter term, we will have to contend with unfavourable factors such as central bank efforts to cool down the economy, a looming contraction in liquidity and the decline of greedflation. As a result, our portfolios are only slightly underweight equities.

“As for bonds, the fact that central banks might tighten beyond current market expectation is not yet worrying for duration,” Melman continued. The middle and long ends of the yield curve could in fact benefit from central bank determination to defeat inflation as a way of slashing interest rates later on. And hopes can only be raised by continuing disinflation over the coming months. “This is why we are overweight bonds and carry strategies on investment grade and good quality high yield bonds,” he said.

“The fact that we have more confidence in disinflation playing out rather than a new era where artificial intelligence drives productivity and we prefer bonds to equities is simply based on the current environment. There is still a risk of recession and reduced liquidity from central banks overtightening and that could overshadow longer-term prospects based on game-changing developments,” Melman concluded.