Hiking in a recession?
Nothing is as simple as this, but the US was technically in recession in the first half of 2022 as GDP growth was negative in both Q1 and Q2. The Fed raised rates another 0.75% this week but the argument for further increases is looking increasingly weak – except that the peak in inflation remains elusive. It’s hard to find examples in the past when the Fed has continued to raise rates when the economy is contracting but in this case they probably will. At any rate, there is a decent chance that bond yields will keep moving lower in anticipation of the Fed pivoting at some point. Lower bond yields will somewhat offset the negative impact on equity valuations of lower earnings.. Quality in credit and equity exposure remains key in avoiding the worst of the squeeze on business cash-flow.
The US Federal Reserve (Fed) raised interest rates by 75 basis points (bps) on July 27th. The key policy rate is now at 2.5% which has been the level that the Fed thinks represents the long-term neutral nominal interest rates. In theory the neutral interest rate is the one consistent with non-inflationary full employment (i.e. economic nirvana). Of course, inflation is well above the long-term target and that means there are still interest rate hikes in the pipeline. From here, economists would say that policy becomes restrictive with rates above the long-term neutral rate. The market doesn’t believe they can become that restrictive with pricing in the wake of the 27 July FOMC meeting suggesting a peak in the Fed Funds rate of 3.25%. The narrative remains the same as it has been for a while – policy becomes modestly restrictive, the economy slows, brings inflation down and in order to try and achieve a soft-landing the Fed will start cutting rates in 2023. The end-2023 implied Fed Funds rate is below 2.75%.
Stable rates are good
The current pricing of US Treasuries is consistent with that narrative. Yields beyond two years are between 2.65% and 3.0%. As I have suggested for a while, the stabilization of long-term yields is a necessary condition for a more constructive view on other asset classes. Yields in the credit market – in both the investment grade and the high yield sectors – have also stabilized. That is good news for holders of corporate bond portfolios – prices have stopped falling – but also good news for corporates as it suggests that the peak in financing costs might have already been reached.
Outside the US the picture is similar with government bond yields coming down over the last month. The benchmark for the Euro area, the 10-year German government bond yield, reached 1.93% on 6 June and is currently just under 0.9%. European corporate debt yields have fallen accordingly. The same is true in the UK. So across the developed economies, monetary conditions have eased somewhat since early June. Clearly conditions remain much tighter than they were at the beginning of the year, but for now there is some relief and that represents a marginal improvement in the economic outlook.
However, the narrative remains bearish which means investor sentiment remains cautious on risk assets, despite what appears to be a solid summer rally. Energy prices continue to be high, and the cost of living crisis is severely impacting on household incomes and spending. As such, consumer-facing businesses will continue to struggle through at least the second half of this year. Away from that, the news from Ukraine is not getting any better and Europe is at risk from a shortage of natural gas this winter. The risk of rationing and declines in economic activity in Germany and other European economies has been well flagged by economists in recent weeks. Against that backdrop the market is sceptical about how much the European Central Bank can raise interest rates.
Global growth slowing
The shape of yield curves reflects the apparent inconsistency between central bank hawkish rhetoric around inflation and the downside economic risks. This week the International Monetary Fund revised down its growth forecasts in its World Economic Outlook. GDP growth in the advanced economies is forecast at 2.5% this year and just 1.4% in 2023, compared to 5.2% in 2021. Germany, Italy, and the UK are expected to have sub-1% growth next year, an annual average that leaves open the chance of one or several quarters of negative growth. In other words, a recession. China is the only major economy forecast to have stronger growth next year, allowing emerging markets in aggregate to post a slightly better year. However, outside of China, most large emerging market economies will see economic slowdown in 2023. It is a truly global slowdown in no small part due to the massive shift in terms of trade between energy consumers and energy producers.
Tightening into weakness
Those annual forecasts mask the fact that the downturn has already started, keeping investor sentiment weak. The advance Q2 US GDP report showed a second consecutive decline in GDP. The data revealed the weakest quarterly growth in consumer spending since the COVID lockdown and weakness in business and residential investment. More frequent data has also deteriorated. The Institute for Management and Supply (ISM) index of manufacturers has already dropped below 50. This index has been below 50 on more occasions than the National Bureau of Economic Research (NBER) has recorded an official US recession, but no recession has occurred without this symbolic level being breached. Similar indicators in Europe have also fallen sharply. The extent to which central banks can continue to keep raising interest rates into a clear economic slowdown has to be questioned. The argument for being overweight fixed income in a scenario of worsening growth is a persuasive one.
July has been a better month for investors with positive returns across asset classes. That has been a relief after the awful first six months of the year. The performance of equities and bonds in the first half was entirely consistent with the run-up to a recession. Now we have one, a relatively mild one so far, and markets are set to be driven by different factors. In a recession, typically, rates start to fall, and the corporate earnings drop. Bonds are ahead of equity markets in that regard.
The recent rally in equities seems to be more driven by the stabilization of rates than by any positive shift in the growth outlook. Profit forecasts seem too optimistic still, although recent weeks have seen some of the consensus earnings-per-share forecasts for 2023 and 2024 start to come down. History tells us that earnings fall in a recession, and we may only be at the start of that right now. Profit warnings are becoming more common even if the Q2 earnings season in both Europe and the US has not dramatically fallen short of expectations. A wide sideways trading range could define the remainder of the year. How bad the earnings recession will be remains key but more talk of a soft landing for the corporate sector would clearly help deliver better returns in equity markets.
Bond yields are lower than they have been since April, but markets could also be fairly range-bound until central banks feel they can signal an end to tightening. With that in mind the focus should be on quality and income. High quality credit offers much better yields than for many years. In Europe, the credit curve is still quite steep as well with the 7-10yr sector offering a yield of 2.85% in the investment grade world, compared to just 1.9% in the 1-3yr maturity bucket. There is more of a pick-up in yield as maturities are extended in credit than is the case in the government bond market.
As discussed last week, quality in equities should see most resilience in terms of earnings. Dividend payers are also likely to continue to be favoured. The S&P Dividend Aristocrats Total Return index has outperformed the broader S&P by around 6% year-to-date. In Europe, the UK, French, and Spanish markets are where dividends have tended to make up a greater share of total returns in recent years.
Quality of cash-low
The Bank of England is up next with a rate decision on 4 August. We expect a 50bps hike. By then, English speaking central banks (US, UK, Canada, Australia) will be well advanced in their tightening cycles. Central banks like to be boring and markets like them to be somewhat predictable and, after a difficult start, that is where we are. The monetary tightening phase is likely over in terms of the impact on market pricing, what matters now are things that are more uncertain. Earnings, geo-politics, and erroneous fiscal policy actions (tax cuts in the UK and Italy, for example) create uncertainty for investors. Building portfolios against the risks created by these uncertainties is challenging, hence the argument for a significant allocation to quality of cash-flow in credit and equities. Taking a medium-term view the upside could be played by an exposure to high yield, while “recession defensiveness and a monetary policy pivot” argues for having longer duration in fixed income, particularly in credit.
All the best and have a good weekend and good luck to the Lionesses.
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