Commentary: Higher for longer
A more hawkish US Federal Reserve and the resumption in the oil price rally has dashed hopes of aggressive pre-emptive rate cuts in 2024. As the market shifts from pricing in a soft landing to a regime where rates stay higher for longer, financial conditions are starting to tighten just as the economy starts to roll over.
Volatility returned to markets in the third quarter, where markets went from pricing in a soft landing (where central banks will cut rates as inflation falls without the economy rolling over) to pricing in central banks keeping rates higher for longer. The price of oil rallied almost 30% for the quarter in USD terms, causing many to question whether inflation would start to trend higher into year end. A slightly hotter than expected US inflation print combined with a more hawkish Jerome Powell forced the market to remove two of the cuts anticipated in 2024. Bond yields rose across the curve and the USD rallied, putting pressure on risk assets.
Back in our July commentary, we highlighted real wage growth will keep the consumer afloat for longer than we originally anticipated. Rather than joining the soft landing camp, we stated that “while this means the economy will likely be hotter than we expected, it also means that the market might be wrongfooted on the soft landing scenario and may quickly pivot to price in a higher for longer rate cycle, which could put pressure on US equity multiples and US duration.” Since then, 50bps of US rates cuts have been removed from 2024 expectations, UST 10-year yields have risen over 60bps, the 2s10s curve has steepened over 40bps and US equities have fallen over 6%.
Financial conditions tightening
Recessions usually occur when hard and soft data deteriorate at the same time. Central banks are usually commended for engineering a soft landing when they manage to ease financial conditions before it starts to impact the real economy. Unfortunately, this recent bout of financial conditions tightening is occurring exactly when we expect the real economic data to roll over. The move in oil price may not have much of an impact on core inflation, but as we saw in 2022, it can have a dramatic impact on the wealth effect for US consumers and government bond yields. With Saudi Arabia cutting production and the potential for Putin to weaponise oil into the upcoming winter, oil shocks cannot be ruled out.
This is occurring at the same time that the US Treasury needs to issue over USD$1.5tn of new bonds to fund the federal budget deficit but also roll over another $2.5tn next year from maturities. Until recently this hasn’t impacted liquidity as most issuance since the debt ceiling resolution have been in short dated bills, but since August the issuance of longer dated coupon bonds have surprised to the upside. In conjunction with the Federal Reserves’ USD$95bn of quantitative tightening per month, there is expected to be a sustained flood of issuance, pushing yields higher. With foreign central banks like China’s cutting exposure to US treasuries (China’s holdings are down over 30% since the 2018 peak), the onus is on investors to absorb these new issues, who are more price sensitive. Given the uncertainty over inflation, we think bond market volatility is likely to remain elevated, keeping financial conditions tight.
Unemployment to rise to defend margins?
We have seen rolling recessions across economies since COVID-19, with strong services more recently offsetting weakness in manufacturing. We are now seeing services roll over, bringing composite PMIs down. Europe and the UK have seen composite PMIs fall decisively through 50 and with negative 6-month momentum. US composite PMIs are holding up but hovering at just 50.1 with momentum also rolling over. With this backdrop we view expectations for US earnings to rebound by 12% next year as optimistic.
Sales volumes have been falling over the past few quarters, but companies have been offsetting this with increased prices, boosting margins. We believe it is unlikely we’ll, see a large increase in sales next year. Most of the expected increase in earnings is coming through from expected margin improvements. It seems unlikely that companies will be able to improve their interest expense next year so they will have to focus on either price rises or reducing labour costs. Companies were able to push through price rises when inflation was rising but we find it unlikely that consumers would stomach more ‘greedflation’ in 2024. If they do, then this will place upward pressure on inflation which would further exacerbate the volatility in bond yields and financial conditions.
We feel the most likely course of action is to reduce costs, where most costs are currently concentrated in labour. Final producer prices (PPI final demand) minus unit labour costs are now negative, highlighting the impact labour will have on corporate margins. Hours worked in US manufacturing continues to fall, consistent with companies who are holding on to labour but have less work to give them. The recent fall in unfilled job vacancies and the US quit rate (high quit rate implies employees are confident they can find a new job easily) could perhaps signal to small business that its now safe to downsize their workforce. If corporates do decide to shed labour in defence of margins, this will likely push up the unemployment rate when the economy is already stagnating, increasing the likelihood of a recession. Our recession models are still flagging a high possibility of recession, so this bears close attention.
Chart 1: How long will business hoard labour?
Source: Schroders, Refinitiv, August 2023. ULC refers to unit labour cost. Subtracting ULC from PPI Final Demand fives a measure of how much profit producers are making after accounting for labour costs
Portfolio positioning shifts
We recognised early in the quarter the risk of higher yields for longer dated US Treasuries and the impact this would have on other markets, and have been busy reshaping the duration exposures of the Fund. Along with cutting total duration exposure from a high of 3.0 years in June to 2.3 years at the end of September, we shifted exposures away from the US, towards Australia and Europe, and shifted exposure away from bonds with maturities greater than 5 years. We also removed 0.5yrs of exposure to US 10yrs and replaced this with a risk-reversal option strategy for zero premium, which buys us back in if yields fall to 4.1% or rise to 4.7%. These changes have significantly reduced the negative impact of higher bond yields (lower bond prices) on the Fund’s return. We maintained our equity allocation of 22% under the surface but rolled out our 5% notional S&P 500 4500-4000 put spread to December. We also maintain our 7000 December put on the ASX. Our delta adjusted equity position is 17%, but thanks to convexity, our equity weight will rise to 22% if the market rallies or drop to 13% if the market continues to fall.
In the meantime we hold elevated levels of cash, which we have earmarked to deploy into equities if we see valuations adjust to our base case and high levels of investment grade credit to earn carry in the portfolio. Within investment grade, we prefer Australia and Europe, where spreads are much wider and offering compelling value (cheap to very cheap), pricing in a recession, relative to the US market where investment grade spreads have yet to widen materially. Exposures to high yield bonds remain neutralised by credit hedges, as we believe spreads are too narrow for the growth risks ahead and increasing risk of default.
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