The weakness we are seeing now globally is pervasive. The manufacturing Purchasing Managers Indices (PMIs) are sinking, with a lot of them falling below 50 which signifies contraction. Services PMIs are also following suit, which is typically what you see when you go into a recession.
On top of that, we are beginning to see some central banks beginning to waver a bit. The Bank of Canada raised its key interest rate by 50 basis points in October, lower than the 75 basis points increase consensus expectation. The Reserve Bank of Australia (RBA) this week raised interest rates by 25 basis points, sticking to smaller rate increases despite inflation touching the highest level since 1990. The RBA’s tone was dovish, too.
The macro scene is beginning to lead to a divide amongst several monetary policy committees around the world.
In addition to PMIs, what’s particularly concerning is the fall in housing markets in major economies including China, Australia, New Zealand, Canada, the UK and the US. China’s property market is particularly going through a difficult time, which can have a bearing on its economic growth. That can have an adverse effect on global growth as China is the world’s second largest economy.
The difference in yields between the US Treasury notes due in three months and 10-years has historically been an accurate indicator of predicting recession. It’s been inverted now for 6 days, and some reckon believe that if it remains inverted for ten days or more a recession is a near certainty.
The Federal Reserve (Fed) are still hawkish. Inflation is too high, but the economic data is going south. In my view that should translate into softer inflation sooner rather than later. The Fed are relying on lagging indicators such as inflation and unemployment for their monetary policy decisions and there is a growing risk they may end up doing even more damage to the US economy. As an aside it is worth highlighting that according to a survey, 37% of businesses in the US failed to pay the full amount of their rent in October and as much as 50% of restaurants failed to pay their rent in full.
In terms of positioning, valuations across investment grade debt and parts of the high yield market are looking compelling. Still, credit selection is important in this environment since default rates are set to climb in the coming year. Therefore, we prefer defensive sectors and secured paper in sectors such as telecom and cable, as well as bonds secured on property.
Over the next 12 months as the global economy continues to slow, there’ll be a pick-up in debate about whether central banks should start easing policy. Medium to long-term government bonds in Australia, US and New Zealand look attractive to us. We believe South Korea also offers opportunities as it is going through a demographic cliff and the housing bubble is beginning to crack.
Demographics is an important driver of economic activity as it affects demand and investment. For an economy to grow you need rising productivity and a growing labour force and we don’t have much of either in most of the world today. Furthermore, typically, a person in their 70s spends half what they would have spent in their 40s, when demand peaks. That is significant as 70% of the US economy is the consumer; in Europe it is 60%. Therefore, an ageing society tends to be disinflationary. Also, in an ageing society, the amount of investment is likely to be somewhat less than in a young vibrant society.
The main reason why inflation has remained elevated in the last couple of years or so is due to a surge in money supply growth brought about by monetary easing and aggressive fiscal stimulus unleashed by central banks and governments to battle a Covid induced slowdown. The US alone injected about $9.5 trillion into its economy and some of that liquidity is still lurking around and creating these high inflation numbers. However, money supply growth is collapsing and the three-month annualised numbers at -5% are similar to those seen during the Great Depression. The invasion of Ukraine by Russia also gave another big shot into the arm of the inflation trade.
If you look back over the last 100 years, inflation has come down by nearly 7% on average during a recession. That’s why the Fed is trying to induce a sharp slowdown. Over the course of 12 months or so we expect inflation to soften quite considerably, and in our view that makes fixed income an attractive asset class once again.
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