Commentary: Can central bankers thread the needle?
Central bankers have given themselves a tough job; to fight inflation without tripping the economy into recession. July’s rebound in equity and credit markets suggests they will be successful, but interest rate markets are not so sure. We have increased duration, but remain wary on credit assets.
Outlook remains challenging
Most global financial assets performed well in July. Weakening economic conditions supported the view that central banks will need to pivot from aggressively hiking rates in 2022 to cutting rates in 2023. This led to a broad rally across bond markets, as expectations for higher interest rates in 2023 was moderated. The backdrop of falling longer term bond yields provided a tailwind for equities and credit which retraced some of the recent losses inflicted on investors in the first half of the year.
While fundamental growth indicators have started to deteriorate, there is only limited evidence at this stage that inflation has peaked in the US. Expectations remain that Australia’s inflation rate will peak six months later, although this remains uncertain. The US Federal Reserve (Fed) raised cash rates by another 75bps to reach their ‘neutral’ rate of 2.5% and commented that 75bps is not off the table at the next meeting. We are of the belief that the Fed will continue tightening well above the neutral rate until inflation meaningfully rolls over, regardless of the short-term growth outlook. Powell has stated that taming inflation is the Fed’s top priority, even if it comes at the expense of growth and employment in the short term.
Recession dashboard flashing red
This aggressive tightening and focus on squashing inflation is occurring against a backdrop of deteriorating growth fundamentals. The US has entered a technical recession, given the two consecutive quarters of negative real GDP growth, but unemployment remains very low. Our US recession dashboard, which led us to materially de-risk the portfolio earlier in the year, continues to flash red with 45% of its indicators pointing to recession. This model last hit 45% in 2018 and just before 2020, which helped us de-risk ahead of the COVID sell-off. Currently three indicators are at the threshold limit but not yet breached, which if triggered would move the model up to 55%. The last time the US recession model breached the 50% mark in the past 20-odd years was just before GFC recession.
The strong labour market is one positive that some market commentators are pointing to as to the reason why this technical recession wont morph into a deeper one. However, all three of the recessions of the 1970s began when employment and monthly changes in payrolls remained strong as unemployment is a lagging indicator. Looking back through history, the only time an official recession in the US failed to follow a technical recession was back in 1947.
Credit card balances point to weaker consumption
While the labour market remains strong, we do not believe consumer finances are in healthy shape. Despite strong nominal wage gains, real wage growth is the most negative in over 75 years, which explains why consumer confidence is plummeting. Consumers have worked through their COVID relief payments, with the US savings rate collapsing to the lowest level since 2009, and according to the New York Fed, credit card balances grew 13% year on year, the largest increase in more than 20 years, as credit is drawn down. This points to weaker consumption moving forward.
This will ultimately put pressure on corporations. Companies will find they can no longer pass on price rises to consumers who are already depleted and falling behind in real terms. This will erode margins as wage and input costs remain high. Slower activity will lead to volumes rolling over, which all points to weaker corporate earnings growth ahead. We believe a ratcheting down of earnings and a more hawkish central bank will weigh on equities and credit and therefore we remain defensively positioned.
Against this backdrop, we are aware that markets don’t always move in a straight line and while we retain a defensive posture overall, we are seeing pockets of opportunity. The rebuild in term premia and credit risk premia are presenting opportunities to invest part of the large cash holdings we have accumulated. Outright yields in investment grade credit have moved to levels where the balance of risks is more in favour of investors. Elevated yields improve the outlook for absolute returns, as assets can withstand greater variability in market yields and still deliver a positive return over a one-year time frame.
High yield credit not yet compensating for risk
While investment grade credit is one segment we have been adding, we continue to view high yield credit to be expensive, given the growth outlook. While high yield credit did rally over the month, we believe the downside or tail risks are not yet significantly priced in. Currently trading around the historical average credit spread margin, we view this as offering insufficient risk premia for slower growth and higher potential default rates. As we have seen many times in the past, high yield spreads can gap much wider. Since recession risks have not yet been fully priced into the riskier segments of credit markets, we believe the reward does not compensate for the risk.
We have been adding to duration recently by reinvesting some cash into the Australian government bonds where we see current yields as reasonably attractive. We will look to add more duration to the portfolio when we believe the risk return dynamic moves further in our favour.
We remain tactically defensive
We continue to use currency exposures as a downside risk hedge to diversify the portfolio. If we do head into a meaningful growth slowdown, the Australian dollar tends to weaken, providing gains on foreign currency exposures. We retain a long US dollar position which we believe will provide a reasonable risk hedge in an economic downturn.
Overall as we move through this transition phase, we remain defensive and retain elevated cash levels but are looking to access more attractive yields as they present. Our active approach allows us to tactically position and manage portfolio exposures to allow us to deliver income but also manage downside risk, in what remains an uncertain market environment.
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