Inflation and rate concerns ease but default risks remain
Higher carry in bond markets – i.e. where investors can borrow at a lower interest rate and invest in an asset providing a higher rate of return – means fixed income returns should beat inflation this year. And they are on track. Inflation continues to fall and central banks, having increased rates again in May, should be on hold for a while. This suits bond returns, as would any cuts in rates, or evidence that a recession is coming. Equity market returns are ahead of inflation but, unlike bonds, they are more at risk from any signs of recession leading to a more pronounced decline in earnings than seen so far. A US recession and rate cuts would be nailed on if there is no agreement to raise the debt ceiling and the US defaults on its debt obligations. It probably will not come to that, but it is worth considering how investors would react if it did. My view is that such a shock would trigger an immediate political resolution. As such, it would be - as they might say in the States – one heck of a buying opportunity.
Equities have been the best inflation hedge so far this year - or rather, large-cap equities have been. Large companies have benefitted from the inflation impact on sales revenues while also being in a much better position to control costs than small and mid-cap firms – although US banks have underperformed for obvious reasons. This is all reflected in the performance of stock indices relative to expected inflation rates for 2023. The NASDAQ and other growth indices have outpaced consumer price increases, as have European and Japanese equities. Small and mid-cap, as well as broad emerging market indices, have failed to keep up.
Higher bond carry
In the bond market, higher carry should allow full-year total returns to be above average inflation rates for the year. Short duration and high yield strategies have benefitted from the rise in short-term rates over the last year while longer duration strategies have seen yields fall, as markets anticipate lower inflation and interest rates going forward. Unless there is a significant weakening in credit markets in the second half of the year, fixed income returns are likely to be positive in real terms across the board.
Are we at the peak?
Investors need to see asset returns beating inflation after the dreadful real returns of 2022. The ‘preferred scenario’ for the remainder of the year is for inflation to continue to decline, which helps real returns, and for the interest rate cycle to peak soon. We had news on both fronts from the US over the past week with the Federal Reserve (Fed) moving its policy rate to 5.25% in what may be the final hike of the cycle. In addition, there was a further decline in inflation with the headline Consumer Price Index dropping to 4.9% in the 12 months to April. However, the core inflation rate remains sticky with the monthly increase in the core index at 0.4% - a pace it has maintained for the last five months. The risk is the Fed could still hike again, or is unlikely to rush into cutting rates, an action which is very dependent on the real growth data. Outside of the US, the European Central Bank is still suggesting additional rate hikes but the Bank of England may have also reached its own cyclical peak in rates. As such, we are likely at the peak of the central bank tightening cycle, and that is a good reason for celebration.
The preferred scenario could continue to see markets delivering modest real returns. Bonds do offer a potential buffer to any possible equity volatility while declines in corporate earnings could be limited by the ongoing lift to nominal revenues from residual inflationary pressures. Interest rates on hold and only modest declines in core inflation mean the macroeconomic narrative will not change that much. For investors, there could be a reluctance to commit cash to the market in case we do eventually get a recession. A recession-induced correction in equities and credit would generate opportunities for better real returns going forward as inflation would decelerate much more quickly. At present, all of this is conjecture, as signs of a recession are still relatively limited. However, caution on equity markets is warranted. At an aggregate level, earnings growth has turned negative. With most companies in the S&P 500 index having reported, the weighted earnings growth for the latest quarter was -4% relative to the same period last year. For EuroStoxx, earnings were flat on the year - caution, but not outright bearishness.
There is another scenario, however. That is a US debt default. Treasury Secretary Janet Yellen has warned the Treasury might not be able to meet all its spending obligations as early as the beginning of June. A default on US debt would be a massive shock to the global financial system – most likely leading to rising volatility, a weaker dollar, evaporating money market liquidity and a stock market crash. Faith in the US government has been a key building block of trust in global financial markets. If there is a default – and any form or size of default would be hugely symbolic – that faith could be tarnished for a long time. The repercussions would be global as well, through both global bond yields and the dollar.
Debt ceiling issues
I am not going to go into details on the technicalities and politics of the debt ceiling debate. For that, I encourage you to read a paper by my colleague David Page which can be found on the AXA IM Investment Institute. There are already some signs of markets pricing in the non-zero (but probably very low) risk of a default. Treasury Bills that mature just before 1 June are trading with a yield of around 3.8% to 3.9%. Those that mature after 1 June have yields around 5.2%. The dollar has been weakening in the foreign exchange markets with the dollar index trading near its lowest levels of the last year over recent weeks. More dramatically, the one-year credit default swap on US Treasuries is currently trading at 180 basis points (bp) compared to an average of 10 to 15bp historically.
Growth slowdown and rate cuts
Under the worst-case scenario we need to consider slower real growth given the disruptions to aggregate demand from reduced government spending, private sector investment and consumption. There could also be negative wealth effects if the stock market corrected lower amid the chaos generated by a default. We should also consider the Fed’s response. Undoubtedly more liquidity would be required. The Fed might also have to cut rates in response to heightened market volatility and the deterioration in the growth outlook. The risk aversion would lead to lower long-term bond yields given a recession would be more likely and happen sooner than under other scenarios.
There is a general theme that investors have acted cautiously this year and there is frustration at missing positive returns, particularly in equities, but now is not the time to use all the dry powder. Either markets keep grinding higher in the preferred scenario or there is a reset caused by a shock. The latter would suit many, given that valuations of risky assets would be much more attractive. A US debt crisis leading to rapid rate cuts and a sharp slowdown in growth would be the buying opportunity many have been waiting for.
Deals and elections
The US political backdrop is making it difficult to define an investment stance around this issue. Outside of the US the view is that a deal will be agreed between Congress and the Administration because not doing so would be crazy. Inside the US there is a lot at stake politically, which means the issue will get taken to the last minute. A compromise to temporarily extend the current debt ceiling might be reached, with all parties promising to focus on the underlying fiscal position (which needs attention). September will see the usual budget process reach a climax so a temporary extension until then might be an option that suits all sides. By then we will be not much more than a year away from the Presidential election. Both major parties will want to look good on fiscal issues and neither will want to be responsible for shutting down the government for an extended period and defaulting on the very system that keeps America running. What kind of risk premium to apply to US assets in the run up to the election will be very much next year’s story.