Nothing has changed in that time. Central banks have already achieved significant levels of tightening, much of which is yet to affect global growth. Much slower growth, further tightening (including tapering), lower medium-term inflation and increasing risks are on the horizon. We have high conviction that these factors will eventually force central banks to pivot in a bid to preserve financial stability and avoid even worse economic outcomes.
Yet what has changed recently is the gradual increase in the risk to the financial stability of the markets, notably over the last six weeks. and this is obviously a very different concern from broader growth and inflation worries. After many years of low interest rates and easy monetary policy, we fear that hidden or underappreciated leverage has built up in parts of the market. Financial accidents tend to occur when such leverage moves centre stage as a result of a meaningful market move that uncovers the vulnerability in the system. In the past, examples of such moves have been the US dollar rallying hard, a material jump in oil prices year over year or when longer dated interest rates hit certain thresholds. In 2022 we have suffered all three! As a consequence, we see the rest of the year and the early months of 2023 as a possible “crunch time” for financial markets and remain alert to early signs of further instability emerging.
In recent conversations with clients, we highlighted the potential for something to break, with plenty of potential suspects. Of course, the first shoe to drop is always the unexpected one. In other words, we did not really forecast the hours of panic in the UK Gilt market in the last week of September and the material volatility of the first weeks of October, with a serious risk coming from the UK pension system itself and “boring” liability-driven investment (LDI) mandates. Nevertheless, this is a clear example of those areas of unexpected fragility that we have flagged here.
The reaction was a dramatic policy shift from the Bank of England, that went from Quantitative Tightening to ‘temporary’ Quantitative Easing in a matter of two days. This should not come as a surprise. While price stability is usually the main mandate for central bankers, the same central bankers are also the guardians of financial stability. When financial stability is at stake lines blur and they can be forced to act to preserve the system.
In our ’crunch time’ thesis we see at least three major areas of weakness
- The sharp tightening in financial conditions and the possible second order ramifications that might follow. The LDI mandates in the UK is a clear example.
- China. In the last few months China has been covered slightly less by the press. The unwinding of a secular bubble for the property market however is still ongoing. With a longer time horizon, it is hard to reconcile an economy rooted in construction and infrastructure spending with worrying projections for population growth, a desire to avoid ‘flood like easing’ and staggeringly high GDP targets.
- The housing market. While China has its own housing problems many developed markets are not in a bright spot either. After the parabolic growth in house prices experienced in the last few years, the US, Australia, New Zealand and the UK are now starting to experience more modest price rises and in some cases even falling house prices. Tighter financial conditions have made housing increasingly less affordable and while adjustable-rate mortgages are not a major problem in the United States, they are definitely a concern in the UK and in Australia.
These are just some of the areas of fragility that we see at this point in time (other areas might be the energy crisis in Europe, geopolitics or liquidity mismatches), all of which have the potential to generate sharp and significant market pricing adjustments in the future.
It’s not only a story of financial stability but also a story of lower growth and inflation. September and October have seen yet more inflation numbers coming in ahead of expectations, but we think that inflation will eventually come down even though not at the speed that the US Federal Reserve would like to see. Consumer sentiment remains weak, inventories keep rising (e.g. Nike, Micron Technology), durable goods orders show contraction and the components of the ISM for new orders and employment has collapsed. These are signs that yet again bring us to think that some disinflation might come from goods in the future quarters. Commodities keep edging lower, easing pressure on headline inflation numbers, US house prices are slowing down, and for the first time in August we received reports of falling rents. Effectively shelter has been a major contribution to growth in CPI in the last months. While we should not downplay such readings, it is also important to consider the structurally lagging nature of rent measures within CPI.
Outside of the ISM components, the US job market continues to show overall strong numbers, but the fall in job openings we’ve seen more recently (although from a very high level) might be a first signal that the tide is turning. Additionally, more and more companies have been announcing hire freezing or job cuts (last ones being Stanley Black & Decker, Meta, Softbank, Gap and Boeing).
The adjustment process for inflation has been extremely painful so far for investors, but it’s not all grim. Valuations for fixed income assets on an all-in yield basis look increasingly attractive (especially relative to equities). We see an even bigger opportunity in duration and government bonds in the United States, Australia and South Korea. At the same time, the recent widening starts to bring credit spreads in a more attractive territory. Looking at Europe for example, the lower quality segment of the investment grade market (bonds rated BBB by major credit rating agencies) and the higher quality segment of the high yield market (bonds rated BB by major credit rating agencies) are offering today spreads versus current yields on German bunds not too far from those seen during the COVID crisis. Even very defensive names in the telecommunication or healthcare space are offering today yields in the 7-9% range.
In short, long-term investors and those hungry for income can definitely find value in this market.
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