“The report of my death was an exaggeration,” the American humourist Mark Twain quipped after newspapers mistakenly published his obituary. We can probably say the same about the prognosis of recession swirling in the financial markets now.
There’s no doubt the backdrop for growth is challenging. China’s stringent zero-Covid policy continues to disrupt supply chains. The Russia-Ukraine war has pushed up commodity and food prices. Given these disruptions, questions are being raised about the future of globalisation, which has for decades kept a lid on inflation. In the U.S., the highest inflation in 40 years has forced the Federal Reserve (Fed) to embark on tightening monetary policy through a combination of rate increases and shrinkage of its balance sheet. The extraordinary stimulus in the aftermath of the global financial crisis and the pandemic that underpinned growth is being withdrawn as soaring inflation turns up the political heat on policy makers.
Some recent indicators from the world’s two largest economies have not been encouraging either. The U.S. economy unexpectedly contracted in the first quarter, while a survey of purchasing managers signalled a deceleration in business activity. US retailers Walmart and Target have issued downbeat forecasts, and Amazon is lamenting about its excess warehouse capacity added during the pandemic. China’s growth engines are stuttering, with industrial production and retail sales declining in April, reflecting the Covid lockdowns.
Focus on services
However, we are not as pessimistic about the prospects for growth as the rest of the market. We believe a full-blown recession is unlikely as the labour market is still very tight and the reopening of the world will we think also spur demand. Many would say that the labour market data is lagged. On the contrary, we believe that vacancies, jobless claims, and payrolls data are up to date and are reliable metrics to capture the pulse of the economy.
Consumers have amassed a war chest of savings during the pandemic, and governments have not stopped spending either as they seek to address the cost-of-living crisis stemming from high food and energy prices. Even the travails of some retailers could be due to overly optimistic demand projections, rather than lack of purchasing power.
Another factor that we need to account for is a switch in consumer behaviour as the world emerged from lockdowns. At the height of the pandemic, the U.S. and many other developed countries saw an increase in spending on consumer durables, straining supply chains and boosting inflation. Now, we are seeing an increase in spending on services, which may rise further in summer months as travel and tourism pick up, resulting in spending on airlines, hotels, and restaurants.
This shift in consumer behaviour from goods to services can mask demand and confuse policy makers. The strength of commodity and energy prices that we see now could be a reflection of underlying demand as well as scarcity. Energy prices particularly could go up further if China stops enforcing its strict Covid policy, releasing an extra uplift to the global economy.
We think the sentiment around China is overly pessimistic. There’s no doubt growth is going to be weak this year in the globe’s second largest economy, but they may not get a recession in the Western definition of the word and the pessimism around Chinese growth is hard to imagine being any worse. The slowdown will be largely due to their Covid policy, and we don’t expect them to reverse it. Therefore, there’s some chance that China will end up looking a little bit better than current expectations. Global growth would get a big boost if China reduced restrictions, eased financial conditions, and opened up its economy.
We expect inflation to ease in the second half of the year, as central banks focus more on lifting real rates than growth. The statistical base effect and weaker growth in China and Europe may help in subduing headline numbers in the coming months, which could trigger a risk rally. But we believe inflation will prove to be stickier than the market generally expects and may remain some way above target as we head into 2023. On that basis therefore, we see a big rally in bonds as being unlikely from current levels.
Financial conditions in the US have tightened as inflation concerns pushed yields up and most of the world reeled under weaker growth, strengthening the dollar. But the strength of the world’s main reserve currency may begin to fade if growth picks up elsewhere too, prompting the Fed to step up rate increases. Particularly, commodity exporting emerging market economies may see higher growth. We don’t expect the linkage between growth, inflation and rates to be linear.
Many investors point towards the flat nominal bond yield curve as a predictor of recession. But the real yield curve, which is still upward sloping, suggests the central banks need to tighten more. We are watching the situation closely and the next few months will be crucial, considering heightened geopolitical tensions and threat of higher energy prices.
As managers of an alternative fixed income strategy, arriving at a correct assessment in all market environments is key to our goal of keeping volatility low and generating returns. Over the past five years, bond yields have seen significant moves to the downside and upside in a volatile macro landscape. In the past few months, the market’s overarching concern has swung between spiralling inflation and recession, which creates headwinds. We believe that a pure macro fixed income strategy, with limited exposure to credit, is the type of strategy needed to navigate such challenges.
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