In July, markets entered another phase: after volatility in Q1 driven by US Federal Reserve (Fed) hawkishness and war, which deteriorated further in Q2 as recession fears rose, particularly in June, we saw equity and corporate bond markets rally this summer. Why? Optimism that deteriorating economic data would cause central banks to relent on tightening plans, exacerbated by very bearish positioning from investors – a classic “short squeeze” in a bear market.
We’d argue that equity moves don’t reflect reality. Firstly, we don’t think that the Fed is about to pause. Fed Chair Jerome Powell is likely to continue to double down on hiking and tapering plans in upcoming meetings. Firstly, while forward looking indicators are pointing to slower growth, Fed policy is essentially determined by backward looking indicators on inflation and jobs. Inflation may have peaked but is still way too high for the Fed to feel comfortable that it’s going back to target. The US July jobs number came in at a whopping 525k — way above expectations. On top of that, the political pressure on the Fed to curb inflation ahead of the US midterm elections is enormous.
Secondly, while recession has gone from a remote possibility to consensus (here at Jupiter we’ve gone from calling recession on our own in January to a very crowded room this summer), we don’t think that investors have got to grips with the extent of the slowdown in growth that is ahead of us. The squeeze on the consumer has been well known since the Ukraine war started, with food and energy prices soaring, but it will get a lot worse.
Consumers have drawn down savings and added debt to fund consumption, and headroom is running out. The winter will see fuel prices hit pockets hard. While at the margin oil and commodity prices are falling, it’s not enough.
Where US housing goes, the global economy goes. The affordability of US housing has collapsed to levels we haven’t seen for decades thanks to soaring mortgage rates, higher house prices and falling real incomes, and we are seeing housing data roll over: home sales are falling fast. It’s not just the US: housing is deteriorating in Canada, Australia, the UK, Sweden, South Korea, among others. Many of these economies have highly levered housing markets, susceptible to higher rates. The impact on housing takes time to come through and will have a big GDP impact. Housing is 20% of US GDP.
A period of slower growth in China is also well understood by investors, but again we’d argue the full impact hasn’t been priced. The unwinding of the China real estate bubble will take years to play out, the zero-Covid policy is stymieing growth, consumer confidence is low, and a sharp slowdown in durable goods spending in developed economies will hit Chinese manufacturing. The government is trapped between high growth targets that look increasingly unattainable and its unwillingness to return to the debt-fuelled infrastructure spending of the past, which makes stimulus difficult. China won’t bail the west out of a recession this time, it will make it worse. There is even reason to believe that China could well be stuck in a liquidity trap as banks are flush with liquidity, yet consumers are reluctant to borrow. A balance sheet recession in China is quite possible. This could well lead to an extended period of secular stagnation.
Against this backdrop, many investors have allowed themselves to hope the Fed will relent, but we don’t think that happens yet; rather, the Fed will continue to tighten, deepening the slowdown. The loss of liquidity from the Fed tapering its asset purchases has historically affected markets as it happens – it doesn’t typically get priced ahead of time – and further Fed rate hikes are probable in September and beyond.
The longer the central banks pursue the end of inflation at the expense of all else, the deeper and more damaging the growth fallout, and hence the recession, becomes. In effect, this approach coils the government bond spring to the extreme and will ensure that the snap back in yields is particularly violent when the pivot arrives.
In the short term therefore, we remain cautiously positioned. Inflation is slowing, but not yet fast enough to allow the Fed to ease policy. The bond markets in our view better reflect reality, anticipating Fed hikes at the short end, and falling growth with lower rates farther out. The difference between 2 year and 10-year interest rates in the US is today the most negative since 2000. We think this curve inversion will deepen, and as recession fears return to markets, bond yields have much further to fall.
We therefore continue to like duration, especially in the US. We like Australia and South Korea government debt, which are vulnerable to China slowing, and have very leveraged housing sectors that are suffering from higher rates. In credit, we own companies in recession-resilient sectors, and special situations that can survive tougher times.
It’s not all bad news for investors: we think inflation will continue to slow because the most effective cure for inflation remains recession. Commodity prices are already helping; over the rest of 2022 goods disinflation will increase significantly as demand slows against a backdrop of excess inventories. As we move into the turn of the year the stickiest component of inflation, shelter, will start to slow quickly as housing deteriorates.
It will be a bumpy ride as growth worsens, but eventually with inflation slowing, central banks will inevitably pivot sharply to much easier policy. This will bring with it a return to “lower for longer,” which is a strong backdrop for fixed income investors; as yields fall, credit markets are backstopped, and duration diversifies risk assets again. This is a once in a generation opportunity to access fixed income markets – but caution is advised in credit markets: you need to know that what you own can make it through a recession.
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