- The tension between high inflation and slowing growth now has financial sector instability added into the mix.
- Central banks are determined to keep rates restrictive but are now close to their terminal rates, resulting in inverted yield curves, credit stress, and extreme volatility in fixed income.
- Equity markets remain on the expensive side, but are helped by earnings holding up and lower long-term yields.
- The dollar has tended to rally on growth and inflation surprises, but has declined as rate cuts and disinflation become more probable.
- A Fed pause and end to outflows, along with China’s recovery, may help EM investors weather mild developed market recessions.
Recession risks seemingly receded early in 2023, initially helping risk assets resume their Q4 2022 rally. Disinflation was helped by lower commodity prices and warm weather, reducing the sting of the energy shock, which alongside China’s early reopening from COVID boosted global growth prospects while lowering terminal rate expectations for central banks. Goldilocks!
Goldilocks... followed by three bears
Then came three bears: tight labour markets led to persistent “too-hot” job growth and wages, repricing Fed and ECB paths; “too-firm” inflation prints (across Japan, Europe and North America in particular) extended the fixed-income selloff but still saw credit performing well; and finally a torrid two weeks of “too-fast” deposit outflows, bank failures and rescues flipped correlations and sent yields tumbling.
Oil, equities and credit were all trampled, though not to the extent seen last autumn. In the US, the UK and Euro Area, the extent of further hikes is now in question, and cutting cycles have been priced in (Figure 1).
Figure 1. Rate paths have become highly uncertain - Policy rate expectations for end of 2023
Going forward, we believe that rates and credit will ultimately drive other markets. Current sturdy growth and inflation dynamics have pushed back recession calls, which makes it difficult for monetary policy to ease from restrictive, near term. Indeed, many central banks are worried about what the House View terms “entrenched inflation risk” more than they are a “hard landing”.
Our last HV noted that we see equity-bond correlation changing back from an inflation/monetary policy driven environment to one that is more focused on growth and recession risks (Figure 2). What often determines correlations across asset classes is temporary extreme volatility in “common factors”. The high uncertainty and variability of inflation has made monetary policy extremely sensitive to current data, and when this is the case, bad news is good news for bonds and equities alike, and vice versa.
Figure 2. As inflation settles down, expect more growth sensitivity
This could be changing. An incipient credit tightening, and the risk of “credit crunch”, is seen by policymakers as tantamount to several rate hikes: this also makes risk-free government bonds a more attractive investment, even with yields below cash rates in many regions.
There are still two-sided risks in case inflation fails to come down much and growth/credit risks abate, but the asymmetry is growing to the downside for yields. The trillion dollar question is, will this be good for stocks and corporates, and high-yielding EM FX? Once the recession we expect in the US approaches, inverted curves will steepen, perhaps violently, if unemployment increases and defaults accelerate quickly.
This seems unlikely in the next few months, but volatility is set to be with us for the foreseeable future. Japan may be an exception: its steeper yield curve is underpinned by commitment to zero rates, and while correlation to other G10 markets has grown, its yield curve should re-steepen when YCC is abandoned under the new BoJ governor.
In any case, the conventional wisdom of 2022, that a “pivot” or pause at whatever terminal rate is deemed sufficient to get the “fairy tale ending” of a soft landing and disinflation has, like many of the Grimms’ stories, come to a horrid end. Interest rate volatility (particularly in short-end rates) had trended down, but then spiked to unprecedented levels (Figure 3).
Figure 3. Not a common shock: volatility across asset classes
So far this has not propagated fully to equities or credit, though measures such as VIX or credit spreads are showing some modest signs of strain. Earnings and credit ratings have on the whole avoided large downgrades.
For credit markets, the restrictiveness of monetary policy could perhaps be weathered alongside sluggish growth, but it has now become apparent that smaller/regional banks will continue to tighten credit conditions. This will be felt particularly in SME and CRE lending, and larger banks and borrowers will also feel the pinch.
There have been many attempts to chart the Senior Loan Officer (SLO) survey results alongside credit spreads and default rates, but the truth is that the scale chosen matters a lot, and that the lead time from such tightening to a recession is quite variable and not always predictive (Figure 4).
Figure 4. EM (GBI-EM yields and EMBIG spreads)
For now, relatively stable equity behaviour (e.g. VIX and realised volatility) and measures of bond market functioning (e.g. the NY Fed’s Corporate Bond Market Distress Index) help explain why both IG and HY spreads are still far from recession levels.
If we are correct in our analysis that recessions are a likely result of rate hikes later this year or early in 2024, then spreads and defaults will eventually revisit new cycle highs, and current sub-20 VIX levels will prove to be absurdly low. Energy and geopolitical shocks, and increased term premia as the new market paradigm reveals fragilities, are also part of the landscape.
EM credits have proven relatively resilient (Figure 4), and although they are still being buffeted by the global environment, the past spate of Chinese property defaults and frontier market distress have left CEMBI and EMBIG at around 400bp OAS, which provides a cushion against a challenging outlook.
An approaching recession and rising risks would argue for caution or even underweights in equity markets. Yet global equities had gained 20 per cent since their October 2022 nadir, and gave up only a small part of the year-to-date gains since February.
Equities have weathered much bad news, helped by lower rate hike expectations
Equities have weathered inflation surprises, hawkish central banks, and stress in real estate and the financial sector. Realised volatility continues to decline, and the financial market volatility, and worries in Europe and the US about banks, REITs and CRE, is reflected in aggressive central banks being closer to pausing, and lowered projected terminal rates. Valuations have come down from 2022’s excessive levels, but are not extremely cheap either; taking all this into consideration, we have no qualms to stay with a neutral outlook on equities.
To be more constructive, we would need to see lower earnings forecasts and multiples, and/or see growth turning the corner. The UK is expected to benefit despite its weaker growth outlook, as a more dovish BoE helps underpin P/Es through low real rates.
There is also relatively wide dispersion, as interest rate sensitive sectors have underperformed significantly. Lower rates may help growth and tech temporarily, but a downturn will surely weigh on firms exposed to cyclical forces, and provides scope for relative value between sectors (Figure 5).
Figure 5. Equity returns reflect rate sensitivities
We continue to expect a more meaningful medium-term decline in the dollar to take hold as the Fed pauses its rate hike cycle more definitively – indeed, the DXY index has already retreated 10 per cent from its 2022 peak as hikes slowed, coupled with more aggressive rate hiking continuing elsewhere (or in the case of many EMs, higher rates already achieved in 2021-'22).
Emerging market currencies are benefitting from the perceived imminent ending of G10 rate hikes, and the higher rates that their central banks have implemented to fight inflation and FX pressures (Figure 6). Outflows have persisted but that has been met with central bank intervention; high carry and Chinese demand from imports and tourism should help stabilise the asset class after 2022’s grim series of unfortunate events.