Un atterrissage en douceur ?

Market pricing and economic forecasts currently point to a soft landing in the US. That should encourage investors to remain in US equities and credit and be less concerned about emerging markets. Yet soft landings are rare, especially when inflation is high and the unemployment rate low. A peak in inflation in the near term should encourage this view but investors need to keep in mind a scenario in which rates keep going up until something breaks. Under both scenarios, risk-free bonds have a role to play in a medium term investment strategy.

Micromanagement

A soft landing is priced in for the US economy. On current market pricing and consensus economic forecasts, the Fed Funds will be above the consumer price inflation rate by this time next year, but not by much. Not by as much as in previous cycles. That should mean monetary conditions are less tight, the Fed will be encouraged by the decline in inflation, and growth will moderate but not disappear or turn negative. US economic growth is currently forecast to be on trend in the second half of 2023. So, enough tightening to encourage inflationary expectations to remain low and to slow growth enough to keep the labour market balanced.

Great for risk

Sounds great doesn’t it? You can build a bullish argument for duration, credit, and equities on that soft landing scenario. More or less enough is priced into the rates curve to suggest that returns from Treasuries can become positive again. Credit spreads are wide enough to generate positive excess returns. The market yield for US investment grade is only 60bps away from where it reached in 2018 (followed by close to 25% cumulative total returns in the following two years). As long as there is no recession, equity earnings can keep growing. All good. Just wait for next week’s inflation rate to come in below market expectations and we are off to the races.

But…

and there is always a but! This one is a big but. Soft landings are very rare. Most tightening cycles lead to a recession of some sort or at least a period of market volatility (ok, yeah, I know, we have that already). The most recent exception was 2018 when the Fed “pivoted” just in time to stop the economy from really slowing down. It might have been the US-China trade tensions and the slide in the ISM at the end of 2018 that was enough to reverse Fed policy. Reverse they did, with the Fed Funds peaking at 2.5% (only slightly above inflation) and the economy growing at 2.3% in 2019.

Tell me when it hurts

The alternative scenario is that the inflation scare has been so serious that the Fed will keep raising rates until something breaks. Many will feel that inflation will only come back down and stay down if unemployment rises. So, rates might have to go beyond what is currently priced in and the “pivot” will only come when something squeals. It could be emerging markets already battered by a weaker China, high inflation, and capital outflows. It could be that the dollar ramps higher versus a weaker growth impaired euro. It could be something domestic, like the housing market or deteriorating credit markets. It may be that political pressure will come to bear on the Fed if unemployment does rise (the Administration will not want unemployment rising heading into the 2024 election year). My point is that forecasts of “terminal” rates are really derivative of what happens to other economic factors – US growth, the global economy, financial markets and even politics. In addition, we don’t really understand what impact balance sheet run-off will have.

Bonds for all seasons

In a scenario where rates go up until something breaks, the challenge will be to guess what breaks first. Hedging against risk assets being the victim of an aggressive Fed cycle means owning safe assets like government bonds. Maybe that is why long-term yields remain low – holders are holding on.

Near the peak?

All economic data releases are not equal. Next week’s release of CPI data for March is important for markets if investors conclude that it is the peak. It has the potential to be ugly – given the 20% increase in gasoline prices in March - but the consensus forecast on Bloomberg at the moment is for a monthly increase of 1.2% and a year-on-year increase of 8.4%. If it is the peak and if there is then more confidence in forecasts of inflation heading back to below 3.0% over the next two years, then maybe the Fed won’t need to squeeze things that much.

Which Fed will we get?

The focus will subsequently turn to the jobs market and what happens to the unemployment rate and wages. That could give a second-leg to monetary tightening.  A recession might be avoided in the next 12-18 months but come beyond that. For most, that is too long a time horizon to be making tactical investment decisions. I think there are three scenarios. The bullish “soft landing” with growth coming back to trend in 2023 and inflation on its way to sub-3%, leaving the current (expected) peak in market rates in-tact. The second, is that inflation does not fall quickly enough, and the Fed feels the need to get “real” rates into positive territory, meaning rates will only peak when something goes wrong. The third is an initial soft landing that is followed by a period of stable rates or even some easing, but with the labour market remaining strong and causing a second wave of inflation angst. After the 1994-95 tightening, inflation did not come down sufficiently and the labour market continued to tighten so the Fed was forced to reverse its 1995 easing, before tightening even more in 1999. That ultimately brought the dot.com boom to an end. 

Short-in duration, high in yield 

The shape of the US yield curve at the moment means you get  a similar yield on a 5-year bond with 4.6 years of duration and the 30-year bond with 21-years of duration. One is four times “riskier” than the other. So – in the short-term and notwithstanding the argument for having a defensive longer-term allocation to Treasuries and other government bonds - there is very much still a good argument for being short duration in global fixed income portfolios (i.e. Choose strategies that focus on the shorter end of the curve, or target a below average market level of duration in full market strategies). Better still, look at short-duration credit strategies. The US high yield market gives a 350bp premium over 5-year Treasuries for the same duration. In Europe, the spread of the high yield market over the 5-year German bund is 400bps for 1-year less duration. I feel credit is fine for now.

Europe

For Europe, US interest rates matter a little given their global impact. Yet the ECB is not likely to raise rates before there is more clarity on the outcome in Ukraine, even if the minutes of its last meeting were a little more hawkish. The last week has seen more calls for Europe to stop purchasing Russian gas. I’ve seen some estimates that would mean a 3%-5% hit to German GDP if that happened. It would of course mean rationing of energy, hitting output in the manufacturing sector and doing little to help ease global supply chain tightness. But as Mario Draghi is quoted as saying “do you prefer peace or running the air conditioning”. Economics sometimes has to become subservient to politics and security. Europe will find it difficult to avoid stagflation. Monetary tightening will be less than in the US but ay policy support for an economy hit by energy will need to come from the fiscal side.

The public ire

The French Presidential election has attracted some market interest. Polls suggest President Macron should be re-elected but there will be a sizeable vote for Marie Le Pen. This should not be a surprise. There is a global cost of living crisis and incumbents will feel the brunt of public ire. Energy shocks always fall most heavily on lower income groups within countries and lower income countries. This feeds support for populists. At the same time, this energy shock is coming when we are supposed to be transitioning to net zero and more renewable (cheaper) energy. The UK government has been panicked into (re)issuing an energy strategy this week, just as the cap on retail energy prices is lifted and retail price inflation is above to hit 9%. What voters and investors need to see is an acceleration of investment into green energy. The oil and gas sector has benefitted from huge windfall profits as a result of the rise in prices and finding policy choices that can utilize those profits would be a strong signal.