Investors are confronted with a dazzling combination of negative performances and a perception of high levels of uncertainty as we enter the last quarter of 2022. The main question that cries for an answer among investors in public markets is: “What’s in the price across equity and fixed income asset classes?”. What kind of recession has been discounted given the resolve by the leading US central bank to tighten financial conditions in order to anchor survey-based and market-based inflation expectations?
Market-based are leading survey-based inflation expectations. The gap might start to close over the following months as base effects on prices of goods work their way through the headline and core numbers. I recall that US market-based inflation expectations have anchored close to the 2.00% targets of the Federal Reserve (Fed). However, second-round US wage inflation indicators remain sticky at levels too high for purpose at around 5% annualized. The signal received over the past week is promising because US jobs openings dropped about 1 million to 10.1 million. That reflects a market characterised by companies looking to slow or even freeze the hiring pace to control staff expenses. The labour market has not yet been confronted by active slashing of jobs. History has shown that such behaviour arises once the recession is confirmed within narratives and across indicators.
Fed Chair Jay Powell will have to see evidence of the three conditions he put forward for a slowing, pausing or stopping of the tightening cycle. First, below trend growth has been established over H1 2022 with US GDP at -1.2%. Even if Q3 might deliver a positive number, forward looking indicators point towards slowing across Q4 2022 and Q1 2023. So here he can tick the box. Second, a softer labour market will have to lead to a reversal in wage inflation. The batch of numbers released last Friday suggests that employment is resilient. Again, we should dismiss first-level thinking and focus on second or third order signals. Cost control will impact non-farm payroll growth and the positive impulse readings that drove us towards 3.5% unemployment seem to have reversed as witnessed by the slowdown in the 3-month NFP (non-farm payroll) averages. Third, on October 13th we might see that trailing headline CPI inflation readings drop towards 8.00%, whilst the core CPI remains stuck around 6.4%. Nevertheless, the month-on-month figures are the ones to watch.
Most of the above Fed indicators are coincident and lagging. That means that the Fed will overtighten with a purpose. The question remains to what extent? With a 75bp hike pencilled in for November 2nd towards 3.75%-4.00%, consensus settles for a 4.5% terminal rate, a move towards 4.75%-5.00% was priced for a couple of weeks over September. The key message here is that the journey is almost coming to an end. The gap on this aggressive Fed rate hike cycle is closing. And with it, the level of uncertainty will diminish. That explains the resilient character of rate, credit and equity markets since the start of October. The whipsaw in the UK around the budget and hesitating Bank of England (BoE) exposed the fragility of markets and asset owners, pension funds in particular. The return towards the Quantitative Easing (QE) instrument by the BoE was a shot in the air, warning ECB and the Fed that financial instability can quickly morph into systemic risk where country debt sustainability perceptions worsen, and the credit worthiness of financial institutions is questioned. A repeat of 2008-2009 for the latter or 2011-2012 for the former is not an option. The ECB will take its cue from the Fed. A policy rate differential around 2.00% is expected as pushing towards 3.00% on the deposit rate would create ”UK style tensions”. Fragmentation pressures, difficult to control through reinvestments only, would quickly spread from Italy towards other EMU members that preach unorthodox fiscal policy as they seek to bail-out their voter base. By the start of 2023, commentators might predict for Fed and ECB alike: ”One and done” as policy rates end the year at 4.25%-4.50% for the US and 2.25% for the EMU.
Next to higher visibility on terminal policy rates, we can look at current asset class valuations and link these with the level of financial conditions tightening. The 10-year US Treasury rate has risen by 2.37% over 2022 starting at 1.51% and closing at 3.88% last Friday. At the same time, the ISM Manufacturing Purchasing Managers Index came in at 50.9, a 2-year+ low, whilst the Service Index was at 56.7, more resilient but slowing as well. The divergence or gap between both and the 10-year rate reached historic highs. Expect the gap to start closing over Q4 and into 2023, as convergence between economic conditions and the 10-year US rate sets in. Mapping the current intensity of OECD central bank tightening over 9 months with the evolution of the composite ISM Index would point to a fall of the latter towards a level of around 35. That leaves two options. Either the economy goes effectively into a hard landing over the next 6 months, taking equity valuations into another leg lower with a Fed pivoting around 4.00% policy rates in order to stabilize markets. Either economic growth shows resilience, leaving inflation readings on a slow downward track bottoming between 3% and 4%. Employment conditions remain on the tight side and the 4.4% Fed unemployment forecasts for the end of 2023 doesn’t percolate. That would lead to range bound markets across equity and fixed income and ‘high for longer’ on US policy rates around 4.5%. Under both scenarios we might have already seen the high in 10-year rates. Indeed, this year’s sell-off in 10-year bonds shows patterns similar to those of 1974-1975, 1993-1994 and 2013. Those sell-offs always featured a three-stage impulse pattern towards higher yield levels. The September sell-off in 10-year rates at just above 4.00% intraday high might been the third thrust higher. Especially since about 70% of participants to the latest Conference Board Consumer Confidence survey is expecting higher rates over the next 12 months.
In IG and HY credit we have reached valuations that protect investors from a 5-year cumulative default cycle that sits far above the worst episodes in history. Will increased systemic risk turn into black swan conditions? The market is fearful. Market liquidity conditions have been worsening for lesser quality names in both spaces. Clearly, the existing market infrastructure has not changed that much compared to the 2008-2009 days. However, central banks toolkits have become multi-functional. Whereas a renewed round of QE by the Fed would seem far-fetched, we do see the ECB reaching out to use its Transmission Protection Instrument if fragmentation strikes. The floor in pricing HY bonds seems to have increased. HY spreads show better resilience than IG spreads, even if their respective primary markets show an opposite picture: HY new issuance is sputtering, while IG primaries are open for business.
The Bank of America Fund Manager Survey reveals an underweight in equity comparable to Q4 2008 levels. At the same time average % cash balances across equity fund managers are comparable to levels witnessed over Q1 2001 amidst the internet technology bubble.
The combination of the most aggressive synchronized policy rate tightening cycle of the past 2 decades, a post Covid supply-demand shock resulting in a stretched inflation scare and a geopolitical and energy power stand-off, has led to an unseen risk aversion away from all financial market sectors. Remember that the narrative over 2021 early 2022 that cash was not a wise allocation in the face of increased inflation fears…has now turned into a narrative that cash is the asset class of choice. The volatility in narratives is as high as the volatility across rates, credit spreads and equity. All might reverse in sync towards lower, sustainable levels once the OECD hiking cycle peaks over 2023. Testing the investment waters today by tiptoeing into liquid fixed income and attractive quality credit and equity can result in shorter recovery horizons.
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Marketing communication. Investing incurs risks. Past performances do not guarantee future results.
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