Commentary: Christmas in July?


After a brutal June, investors welcomed a strong rally in July. This reprieve saw risk-on assets like equities and commodities rally from their lows, but also price gains from risk-off assets like government bonds and the Japanese yen (JPY). This ‘everything rally’ was predicated on perceived dovish rhetoric from the US Federal Reserve (the Fed) chairman Jerome Powell. If the Fed is no longer tightening into oblivion, then government bond yields can come down, boosting equity multiples and reducing the interest rate differential between the USD and low yielding currencies like the JPY. Investors dusted off the Powell pivot playbook of December 2018 and priced in a more goldilocks outlook of falling inflation, stable economic & earnings growth, and a strong consumer. We’re not so certain.

Just like Christmas in July, while it feels good, it often doesn’t live up to the real thing. Fundamental macro indicators continue to deteriorate and while inflation may be peaking, it is still uncertain where it will settle. The US Federal Reserve raised cash rates by another 75bps to reach their ‘neutral rate’ of 2.5%, and despite dropping forward guidance, commented that 75bps is not off the table at the next meeting. Unlike the 2018 pivot, inflation is at 9.1%, not 2.2%, so a pivot is probably premature. We are of the belief that the Fed must continue tightening, well above the neutral rate, until inflation meaningfully rolls over, regardless of the growth outlook in the short term. Powell stated as much in his press conference, emphasising that taming inflation is the Fed’s top priority, even if it comes at the expense of employment in the short term. While he did state that the Fed will be more data dependent, it wasn’t like they were on autopilot beforehand. Over the past few months, as inflation data surprised to the upside between meetings, the Fed had to leak information to the press to adjust upwards their forward guidance for the next rate hike. The Fed was always data dependent – it’s just that now, they won’t feel obliged to let us know in between meetings, potentially increasing policy uncertainty.

Bad news is good news

This aggressive tightening and focus on squashing inflation is occurring against a backdrop of deteriorating economic fundamentals. The US has entered a technical recession after two quarters of negative real GDP and composite Purchasing Managers Indices (PMIs) have dropped below 50. This deterioration in the growth outlook is part of the dovish pivot narrative, reflecting the old adage of bad news is good news as it means the Fed can take their foot off the brake. However, as the Minneapolis Fed president Kashkari recently said, “Whether we are technically in a recession or not doesn't change my analysis. I'm focused on the inflation data… We are committed to bringing inflation down and we’re going to do what we need to do.” And he’s the dovish one.

While it’s a less controversial call now, we remain in the recession camp. Our US recession dashboard, which led us to de-risk 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 there are three indicators that are at the threshold limit but not yet breached, which if triggered would move the model up to 55%. The only time the model has breached the 50% mark in the past 20-odd years was just before the dot com and GFC recession.

Many point to the strong labour market as to why this technical recession wont morph into an ‘official’ recession. However, all three of the recessions of the 1970s began when employment and monthly changes in payrolls were strong. You could even argue this is a feature of an inflationary recession, as employment is a lagging indicator. Looking back through history, the only time an official recession failed to follow a technical recession was back in 1947, which seems like a pretty good track record if you ask me.

Consumers turn to credit

While the labour market remains strong, we do not believe consumer finances are necessarily healthy. Despite strong 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. Credit card limits were also increased by $100bn in the last quarter, the largest increase in 10 years and limits on home equity lines of credit saw the largest increase since 2011. All this points to a consumer who is behind in real terms and is utilising whatever access they have to credit to fill the void. This should keep consumption artificially higher in the short term. But how sustainable is it?

Ultimately, corporations will come under pressure. 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 and slower activity leads to volumes rolling over. This all points to weaker earnings growth going forward. All this while the Fed is forced to remain hawkish as it fights the worst inflation since the 1970s. The market is still expecting strong earnings growth for the rest of the year and rate cuts in 2023, which we believe is misplaced.

Defensiveness prevails

We believe a ratcheting down of earnings and a more hawkish central bank will lead to the next de-rating lower in risk assets; therefore we remain defensively positioned. Given our view on earnings, we remain negative on both equities and credit. That said, positioning and sentiment hit extreme lows, pointing to the potential for a continuation of the bear market rally, until upcoming data can confirm our concerns. We have therefore rotated some of our equity allocation out of Australia, which has performed relatively well year to date, towards the United States, which also helps increase our quality factor. Spreads in investment grade (IG) credit have started to price in a recession and in particular Australian IG credit looks attractive after spreads widened above 180bps, exceeding the 170bps seen during the COVID sell off. While we continue to hold elevated cash levels and defensive positions in risk, we have added to Australian IG credit and removed half of our global high yield protection to build some carry into the portfolio.

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