Bear market continues
Investors continue to experience losses in bond and equity portfolios as concerns about the extent of monetary tightening, inflation and its growth implications continue to dominate sentiment. Central bankers are hawkish. Inflation stories abound. Consumer confidence is shot. But, hold on. Jobs are plentiful, wages are growing, and companies are making money. Fixed income offers better opportunities today to investors, accepting that inflation will eat away at returns in the near-term. Build some duration in portfolios to hedge against what could still be a more significant reaction in equity markets if growth does start to falter into 2023. There are some very cheap bonds around and most of them will redeem at par!
Peak hawkishness ?
It is not clear that we have yet to reach peak central bank hawkishness. I would argue that we haven’t yet despite the concerns about economic growth coming from the squeeze on real incomes. The hawkishness of central bank rhetoric has been ramped up in the last few weeks and talk of one or more 50 basis points (bps) hikes in policy rates has become commonplace now. Indeed, in the US, current market pricing is for a 50bps hike at each of the three upcoming FOMC policy setting meetings – May 4, June 15 and July 27. By then the Fed Funds rate could be 1.75%. The market is also pricing in 80bps of tightening from the ECB this year.
No relief for short-dated rates
Central bankers clearly need to send a hawkish message given that they are behind the curve in relation to inflation. Even though they probably still believe that inflation will come down from current levels over the course of 2002, interest rates still need to be increased to get policy rates closer to zero in real terms than they are at the moment. First, the ECB has to get its deposit rate closer to zero in nominal terms, which appears to be a challenge to the consensus – at least in terms of timing and in terms of positioning rate hikes with the winding down of asset purchases. From a market point of view, the need for the Fed to maintain an expectation of getting the Fed Funds rate to 3% or above and the need for the ECB to convince us that rates will be increased at some point means that there is little scope for short-term bond yields to come down much any time soon. So, curve flattening – especially in the short-end of the curve between overnight rates and the 2-yr to 3-yr sector – will continue.
The question is whether the tightening cycle will be aggressive enough to generate a recession and significant further losses for investors in risk assets. US banks that have released Q1 results so far have generally been fairly relaxed about credit quality, even in consumer facing businesses. It is important to watch housing, as always. Fixed 30-year US mortgage rates have risen by 200bps this year. So far, new homes sales have remained strong and there is no visible evidence of an increase in foreclosures, despite housing affordability having declined. On the corporate side, leverage has generally been lower in recent years and financing costs have not gone up that much, especially for large better-rated borrowers. The yield on US investment grade debt has risen by around 200bps as well, but earnings growth for S&P companies is expected to be in the 5%-10% range in the coming year. We are far from a credit crunch.
Prices squeeze incomes
Of course, it probably will not be policy tightening that is the single cause of a significant slowdown. Consumers are being squeezed by rising prices and that is already evident in consumer confidence and spending data. UK retail sales growth was -1.1% (excluding motor fuel) in March. One reading of consumer confidence fell to its lowest level since it was first published in the early 1980s. Retail electricity prices in the UK are expected to be close to 50% higher on average in 2022 compared to 2021. It’s clear to see that rising prices for life’s basics will mean less spending on more discretionary items. Hence the underperformance of household goods, autos and retail in the UK equity market this year. There is unlikely to be a UK consumer spending boom anytime soon.
Where on the Phillips curve will we land?
The consumer is taking the brunt of higher inflation. Higher rates will impact across economies. Supply disruptions and geopolitics will disrupt production and trade. All of this means lower GDP growth in 2022 and 2023. Yet, employment is strong and labour income is rising. Indeed, the Fed’s Powell this week said that the labour market was too hot! Does that mean they think they will need to do more eventually? We need to wait and see. No-one will want to see a significant increase in unemployment even if a significant increase in unemployment might be what is needed to bring inflation back to 2% if that is what is desired by monetary policy makers. There could be more of a nuanced trade-off between unemployment and inflation. If things like fragmented globalization and the energy transition lead to higher structural inflation, the policy benchmark might have to be more flexible than generalized 2% inflation targets.
Bears still growling
In the meantime, markets remain bearish with April seeing little respite so far to negative returns across most liquid asset classes. Bond yields are moving higher still, credit spreads have widened again after the initial war-widening was reversed during the second half of March. Equity markets are, at best, going sideways. The S&P500 index has been in a 4200-4600 trading range since mid-January, and the NASDAQ Composite has traded between 12500 and 14500. It’s a tough environment, as I discussed last week, as volatility has been quite high. The number of days the change in the US Treasury 10-year yield has been more than 10 basis points has been 8 so far in 2022 compared to 5 in the whole of 2021. For the 10-year Bund the numbers are 6 for this year compared to 1 in the whole of last year.
Nibble at duration?
I am more comfortable with the view that US yields are close to a top around 3%. The Fed has yet to suggest that the Fed Funds rate needs to be substantially above that level, and it is likely that there will be some relief from inflation prints in the weeks ahead. Moreover, the re-rating of fixed income has gone further than that of equities. The Q1 performance for the US Treasury market was 2 times the standard deviation of quarterly total returns since 1975. For the S&P the quarterly drawdown was not even one standard deviation of its quarterly performance history. The nominal earnings yield minus the risk-free rate gap continues to get squeezed in US markets.
Timing, dear boy
Sell-side analysts are becoming more positive on fixed income and there are a number of recommendations to add to duration. In client portfolios, fixed income has been unloved, but yields are at their most interesting levels for some time, while equity market price-earnings ratios are still high (especially in the US). For the moment equities are supported by decent earnings. At the moment, Q1 earnings for the S&P universe in the US show modest positive surprises in aggregate for both sales’ growth and earnings – although with some notable misses in areas like consumer discretionary and utilities.
Build a hedge
I’ve said it before but it’s worth remembering. Equities tend to do worse when the economy really tanks, and earnings are cut. That is preceded by higher rates. On that timeline we are not there yet. But adding fixed income slowly as yields go higher will eventually give a more efficient hedge in a multi-asset portfolio when and if equity returns do turn more negative.
Manchester United got thoroughly beaten by Liverpool last week – a result which appears to have accelerated the decision to complete and announce the appointment of Erik ten Hag as the new head coach. Motivation and leadership are important in sport as well as business, and both have been lacking at Old Trafford in recent months. If United were a stock, they would have been badly de-rated (actually there is a listing on the New York Stock Exchange, but the price has hardly moved this year). So, new management and potential asset upgrades should be good news. A change in ultimate beneficial owners is also being called for by some. A total corporate re-build. With Liverpool and Man City dominating it is going to be a long-way back.