Moment de réflexion

When things are bad, people think they are the worst of times. Today we have inflation, rising rates, slowing growth and polarized politics. Is it as bad as the oil shock of the 70s, the Cuban missile crisis, the impact of 9/11 or the near collapse of the global banking system? Even if it is, there is always recovery, like a wheel within a wheel. Patience is a rare commodity in financial markets but it pays to try and look through the immediate news. Bonds might have bottomed, rate bearishness might have peaked. They are necessary markers on the road to a more constructive view. The risk of set-backs is high, but remember, these are cycles and what goes down goes back up again at some point.

This is the risk in full play

We are living through a downside adjustment. The risks that built up over recent years are materializing, meaning lower economic growth, higher inflation, higher interest rates and negative returns from financial markets. One interpretation of risk is that it refers to the disruption involved in moving from one state to another. In my mind that is what is going on. On a very simple level, monetary policy is moving from its COVID emergency setting to an inflation-busting setting. The transition is painful, particularly for investors in bond markets. So far, 2022 has seen the worst total return performance from global bonds since the early 1970s. It’s painful for equity markets too. Covid era valuations – boosted by excess liquidity – have been obliterated, higher bond yields are pressuring equity valuations and there is a risk that the earnings cycle is about to turn down. The MSCI World equity index has already registered its third worst performance since the 1970s – only exceeded by performance in 2008 – when the financial system froze – and 1974 – following the oil embargo and the after effects of the Vietnam war.

Can you see the peak?

If we knew how long the transition phase would last, we could be more constructive on markets. The problem is we don’t. Any confidence in picking the peak in the inflation cycle has been shot by the April and May data and now a peak in year-on-year inflation rates does not look likely until Q3. Without a peak in inflation, we can’t confidently call that the interest rate cycle has also peaked (in terms of expectations). If we can’t call the peak in rates, we can’t confidently assess what the economic impact will be. Higher inflation means more restrictive policies and a greater risk of recession. Equity market valuations are not at recession levels yet.

Road map

There is a road to being more bullish though. Without being a hostage to fortune there has been some relief in the oil markets in the last couple of weeks. In the US, there are signs that demand is slowing and that some parts of the economy are seeing a build-up in inventories and price discounting. The flash June US manufacturing purchasing manager index (PMI) showed a decline in growth with the index dropping from 57.0 to 52.4. Signs of easing price pressures and slower growth are necessary to get the Fed to suggest that enough is enough. Keep in mind that the Fed wants to get inflation back to target over the medium term but also to achieve a soft landing. That means it will pivot at some point, once the data shows the economy slowing meaningfully. Avoiding a housing market collapse or a financing crisis in the corporate sector is very much in the Fed’s thinking.

Euro issues again

In Europe it might be different. However, the European Central Bank (ECB) shares with the Fed the target of getting inflation back to target. A weaker Euro and the greater sensitivity to the Russian induced energy crisis makes it more challenging. The ECB also wants to contain “fragmentation” risks and avoid a re-run of 2011-2012. Operationally that is a challenge as it needs to tighten monetary policy without creating financing conditions that materially worsen the debt profile for countries like Italy. It’s difficult to see the euro rallying meaningfully with that backdrop. It has to be a fair bet that some form of asset purchases will need to be re-activated in the next couple of years. At the extreme, if conditionality is attached, a return to austerity in some parts of highly indebted Europe might be seen.

Better news for bond investors

The accumulated drawdown in global bonds over recent months is the most *ever*. I said a month ago that the worst of the total return decline in behind us. This week, US bond yields have fallen. As I write, the 10-year Treasury yield is 43 basis points (bps) down from the recent high. The total return index bottomed on June 14th. Newly issued bonds are coming with coupons that are between 120-300 bps higher than average coupons on existing debt. This is good news for bond investors going forward.

Income is king

Even in a period of falling interest rates, income return dominates total return in fixed income. Obviously active fund managers try to capitalize on price volatility to generate better returns than benchmark indices, but income is key over the long-term. Taking representative global, US corporate, Euro corporate and UK corporate bond indices, since 2000 the income component of total return in bonds has been between 95% and 100%. With yields much higher, bond investors should be looking towards healthier total returns over the coming months and years. Yield does not equate to return over short-time periods, but over the long-term it does, so the outlook is much better with US corporate bond yields at 5% and UK yields at 4%. Higher yields also improve the hedging capacity of fixed income in multi-asset portfolios given that duration has greater room to rally/yields to fall, when risk assets come under pressure.     

Worse data in the pipeline

In the short-term the road-map to becoming more bullish is still bumpy. The official economic data are far from indicating a recession at the moment, despite what we can all induce from the impact of higher energy and food prices, rising debt servicing costs and negative wealth effects. The data is likely to get worse before it gets better.  Financial market participants are pretty impatient in terms of waiting for the impact from the change in financial variables to the impact on the real economy. That behavioral trait means many will miss the turning point in markets because the real time economic data will still be deteriorating. But worse data is coming and that could still impact on credit spreads and equity valuations.

Equities still adjusting

It’s a longer road map for an equity recovery. A peak in bond yields is key as that will reduce pressure on equity ratings. Forward earnings yields are still superior to bond yields in most markets, but in the US that gap has fallen and further declines in price-earnings ratios might be necessary to get equities into cheap territory. Earnings expectations are also fairly elevated with the consensus still forecasting 10% growth over the next year. If there is a recession, it will be hard for earnings to grow at 10%.

But, stocks are getting cheaper

However, a sequence of events starting with some turn in the growth and inflation data, which then leads to a peak in monetary tightness and forward looking indications of some easing, will at least provide a degree of comfort for equity markets. Then it is all about growth and earnings and how deep the slowdown is. If Jerome Powell gets his soft landing, equity returns will re-bound and if inflation turns lower over 2023-24 it will be growth stocks that lead the way. After all, labour market tightness, more aggressive unions, higher wages and supply chain issues make even more of a case for technology and automation.

Higher rates, adjust, move on…

Sentiment and feelings are hard to quantify. I am sure I have felt as gloomy and unsure about the outlook in the past (ERM crisis, Lehman collapse, COVID) as I do today. The effects of climate change, the polarization of politics at the local and global level, and how the global economy deals with the post-COVID disruptions to its plumbing are all major sources of concern. But, equally, animal spirits are strong, people want better lives and companies and individuals are innovative. Get back into bonds, short-duration if you don’t want too much risk, and enjoy higher income from fixed income investments. The time for capital gains will come again.

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