Hopefully, your inbox is enjoying something of a summer lull as much of Europe takes a break from the office. The same, however, cannot be said for markets, where the changing consensus and seasonally thin liquidity have kept us busy over the past six weeks or so.
Mid-August delivered a smaller-than-expected increase in the US CPI, followed swiftly by a larger-than-expected increase in the PPI. This second piece of data has put more pressure on yields as it highlights that the battle against inflation is not over. Indeed, market direction swung very quickly from ‘hard landing’ to ‘glide path down’ then to “re-acceleration”.
Equity markets are still pricing prices for a “soft or no landing’, but in fixed income land you still have an inverted yield curve, which signals ‘recession’. What’s changed is that we now expect that recession to be pushed out some way. We’ve been positioned for a weakened H2 2023 all year; it’s becoming apparent that this weakness is going to hit in the closing months of the year, rather than in late summer / early autumn.
The next three months are going to be key in determining if our long view has been correct. We’re not even halfway through seeing the impacts of last year’s US rate hikes come to fruition, but already we’ve had the S&P downgrading regional banks and growing concern regarding the commercial property market. The Federal Reserve (Fed) is expected to remain on pause through September.
We would expect to see service inflation continue to drop as consumers finish up with their summer holiday and ‘revenge’ spending. From here, every data point counts.
Positioning
We continue to run our longer-duration positions. We don’t have any hedges on right now and credit is continuing to perform strongly in response to low issuance year-to-date. This has created a structural tailwind for high yield – resulting in CCCs outperforming everything else this year, something few were expecting. We had positioned ‘up in quality’ and we wait for this to come through as the economic pullback kicks in.
August and September tend to be seasonally weaker months across markets – August because of the holiday season and September because of Jackson Hole. As such, volatility may well pick up over the next eight weeks or so as data flows through. Given we don’t have a strong directional bias for this period, we’ve been digging deep with our bottom-up research and adding to our preferred higher-coupon credits in order to coupon clip.
Our UK exposure remains fairly light. The economic environment is weak but overall OK. The property market is facing some trouble. Wages are ticking up, which is inflationary, but that’s against rising energy/mortgage/rent expenditure, which is draining disposable income. Given the transition mechanism for rate rises is at least 12 months, more hikes from here seem fairly pointless, in our view. We expect the inflation figure to begin with a ‘5’ by year-end.
Europe is more mixed, with Germany remaining very weak but Spain improving. We think Europe’s economic environment could weaken before the US does, making us more cautious on European high yield and more comfortable owning quality government bonds, like German Bunds.
Outlook
The big danger right now is that inflation doesn’t come down. Given people aren’t losing their jobs and consumers continue to spend, we must at least consider the scenario that inflation does not fall as quickly as expected. One consequence of this would be the Fed continues to hike rates and a potential policy error occurs as they overtighten into a market that is already weakening, triggering a recession. The Bank of England could be going this way…
Overall, it’s a tough environment and views are quickly flip-flopping between bull and bear. Right now, the government bond bears seem to be winning with forecasts of a Goldilocks scenario and no recession. But the flip side of that is higher Treasuries, which would cap equity market performance, so sadly there’s no free lunch for investors with either scenario.
