London is not particularly representative of the UK. This means we must be careful not to draw any real conclusions from such a limited anecdotal experience, but certainly when one looks at the US, consumer balance sheets are in robust health post pandemic, for the time being. All the evidence suggests that the consumer is still in robust shape.
Are recession risks rising?
Goldman Sachs’ economics team has said that the risk of a US recession in the next 2 years has risen to 35%. Jan Hatzius said “Taken at face value, these historical patterns suggest the US Federal Reserve (Fed) faces a hard path to a soft landing”. At present, monetary conditions are still accommodative, the economic environment is still relatively robust and the 2s10s inversion has reversed. In fact if one looks at the 3 month/10 year, which is the more accurate recession indicator, it has continued to be very steep. It’s hard to see things declining so precipitously in the next 10-12 months from the charts, but what about the real world and the inflationary impact on corporate margins? What would get us to a recession in 2023? Consensus is usually wrong, and the big question is whether we are underestimating the degree to which both inflation, and central banks’ reaction to it could more rapidly impact growth than we are pricing in. Deutsche Bank now see a deep recession next year as a result of the Fed having to be far more aggressive on interest rates to combat inflation.
Are there any alternatives to this scenario? We need to consider whether a recession is a foregone conclusion and when? Are we looking at stagflation (inflation plus slower growth) or can the US economy weather the number of interest rates rises being priced in, leading to falling inflation as we move into 2023, accompanied by a gradual slowdown - this seems to be the central case at the moment.
Uncertainty still persists
The bottom line is that we just do not know. If we think back to 2021, we were expecting the 10-year to reach 2.00%, by year end, which didn’t happen. Since then, we have blown through most year-end 2022 predictions that were set in January 2021 for where the 10-year may end up. There are so many variables at this point that it makes very little sense to try to position oneself for what may happen in 12 months’ time. What one can do is to look at the evidence we have today. We can argue that a recession is coming as a result of a policy mistake, and equally that inflation may be peaking, and we will see a slowdown, but nothing more. The really important issue is not whether we have a recession, but its longevity and severity. That is what will drive markets.
To my mind, there is enough evidence to suggest that we will begin to see some of the inflationary pressures alleviate over the next 12 months. Either we will see consumer demand falter as inflation bites, or equally we will see corporate margins and thus profitability decline as manufacturing costs rise. This will ultimately lead to cost rationalisation, which will also mean job cuts. That in itself will keep a lid on wages and thus demand. In this environment, weaker, highly leveraged companies will be at risk. Interestingly the market is already pricing in up to 9 rate hikes by this time next year, so duration sensitive Fixed Income (both investment grade and high yield) has already re-priced. Therein lies the opportunity.
A world of weaker growth
Clearly risks are increasing that we are entering a much weaker economic environment. According to Bloomberg analysis, higher oil prices and higher bond yields almost always lead to slower growth with a 12-18 month lag. Nothing particularly controversial but with less consumer disposable income and higher interest rates, the slowdown in activity may accelerate. Truck sales in the US have begun to decline according to Bloomberg. 65% of freight in the US is delivered by trucks so this would indicate a decline in activity. Having said all of this, a lot of bad news has already been priced into bonds.
According to data from Bank of America, year to date investment grade returns by mid-April were -10.5%; trailing only 2 worse points in the 45-year history of the BofA indices: Jan-April 1980 (-11.5% when the US economy had 14.5% inflation in a recession) and Aug-Oct 2008 (-14.3% following Lehman).
This essentially gives us more confidence that most of the pain has already been taken in investment grade and higher rated high yield bonds. If we do see inflation begin to dissipate as a result of either lower oil, China lockdowns, or some reduction in activity (or a combination of all 3) then owning bonds of this ilk makes sense.
How are we positioned?
We have been extremely active with our hedges this year. It has been an incredibly difficult market to navigate. Without going into too much detail, we have re-positioned for the most likely outcomes. Timing aside, it seems as if we will have either a global economic slowdown, or a recession. The severity and longevity is what is uncertain at this point, and really that is the most important point to make here. A shallow recession would be fine. It seems unlikely that the Federal Reserve would hike into a slowdown given the dual mandate of inflation and employment. We have begun to increase our allocation to investment grade bonds, whilst reducing our interest rate hedges, and hedging some of the underlying credit risk we have on the funds; particularly in Europe. On High Yield, we are looking at BB rated credit again. Services continue to be our primary focus given consumer activity. We continue to like fallen angels.
This means we need to focus on quality. We have begun to increase our allocation to investment grade bonds, whilst reducing our interest rate hedges, and hedging some of the underlying credit risk we have across our global strategies, particularly in Europe. In high yield, we are looking at
BB rated credit again. Services continue to be our primary focus given consumer activity. We are therefore more concerned about Europe over the US.
As we have seen with the recent news around Poland and Bulgaria, Europe is particularly vulnerable to Russian gas supplies. The most significant market event will be mid-May when the German contract comes up. Will Germany pay in rubles or have the gas cut off? That is a significant market event and quite binary in the very short term. At present, it sounds like Europe may pay in rubles, whilst cutting off Russian oil, so mitigating any real damage to both companies and consumers.
The US dollar will continue to be strong versus the Euro and other currencies this year. Europe continues to be vulnerable to the Ukraine conflict with energy weaponisation one of the major issues. Consequently, market volatility will continue to be high. There is still a pent-up demand from the US consumer, which continues to be strong, focusing our attending on services spending. This means inflation may remain elevated and persistent for a bit longer than expected, leading to expectations that interest rates continue to rise in the short term. I do think we are over pricing the number of rate hikes and therefore see value beginning to unfold in some areas of Fixed Income.
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