Investment Institute
Viewpoint CIO

Cycle fatigue

  • 16 June 2023 (5 min read)

Whether the US economy experiences a soft landing, a recession or some other outcome, it remains central to the investment outlook. The Federal Reserve (Fed) has not claimed victory over inflation yet, but it has paused its rate hiking on the assumption that 500 basis points (bp) of tightening should impact growth and price rises.

Currently, economic data is not overwhelmingly pointing to recession. There is not a lot of bottom-up evidence. Markets cannot seem to make up their minds on what to expect even if some indicators suggest a recession is nailed on. So, short-duration fixed income remains the main attraction. Equities keep going up but, of course, are vulnerable to any change in the narrative and the economic data flow. Investors should enjoy the summer if they can.

Pause but warnings

The Fed kept its key policy rate unchanged at 5% on 14 June, in line with most expectations. The decision has been described as a “hawkish skip” and the Fed’s accompanying commentary, as well as updated forecasts from Fed officials, suggests there could be more hikes to come. The view is that inflation risks remain to the upside and that the economy is more resilient than thought at the time of March’s wave of bank failures. The decision has cemented a tightening in interest rate conditions which began in early May. The three-year overnight interest swap rate has moved from 3.5% to 4.2% over the last month. With inflation coming down, this represents an increase in implied real interest rates. Putting it another way, market expectations for rate cuts have eased back. Even with the Fed’s so-called ‘dot-plot’ of officials’ forecasts suggesting two more hikes this year, the market is struggling to price in even one full rise The implied Fed Funds rate at end-2023 is 5.22%. The conclusion is that the market sees rates staying at, or slightly above, current levels for an extended period.

Core sticky

This makes sense given that inflation is still well above the Fed’s target. Headline inflation fell to 4% in May but core inflation eased only marginally to 5.3%. The monthly increases in the core inflation index have remained stubbornly around 0.4%, suggesting a core inflation run rate of 4.8%. That is too high. Until the momentum of core inflation eases, the Fed is not going to give up on the message that monetary policy will need to remain tight for some time.

Hard to navigate

So the debate as to whether the US economy experiences a soft landing or a recession remains central to the outlook. Equity and credit markets are betting on the former. With my fixed income colleagues, we have just been going through our regular quarterly assessment of the macro, interest rate and credit outlook. One thing which is clear is that company fundamentals are solid. Strong nominal earnings growth has allowed leverage to come down and borrowers have been able to raise money comfortably in the bond market in recent months, building up cash buffers in case growth does weaken markedly. Unemployment remains low, consumer spending steady and, given the recent decision on the debt ceiling, there is no shock coming from the fiscal side.

Cash remains attractive

The recession, if it comes, has been well flagged. The yield curve became inverted a year ago, money supply growth has collapsed, and credit conditions are tightening. It is no wonder investors are cautious. If you can earn 5% in money market funds and 5.5% to 6% in short-duration investment grade credit, why take any additional duration, credit, or equity risk? The defensive allocation to cash shows no sign of being concerned about re-investment risk when the Fed is telling us that rates will stay high for some time. The T-Bill curve is flat out to a year. The situation is similar in Europe. French Treasury debt with a 12-month maturity yields 3.4% compared to 3% on 10-year French government bonds.

Jobs

I don’t know if the US will go into recession, and if so, when, or indeed how deep it could potentially be. There is so much contradictory evidence now. The real litmus test is the labour market and it has not shown any significant weakness so far. American companies are usually very quick to shed labour if they see demand weakening and profitability eroding. My colleague, AXA IM Head of Macro Research, David Page, and his team have done some work on labour markets in developed economies. Their conclusion is that since COVID-19, labour supply has been impacted by assorted factors including increased long-term sick leave and a behavioural shift which has led to people leaving the workforce in many economies. So, firms are hanging on to workers, reluctant to shed jobs in case it proves difficult to re-hire once growth returns. There is more work to be done on this, but it certainly seems since COVID-19, labour supply in major economies has shifted and contributed to tighter labour markets and higher wage growth. Getting inflation permanently back to or below central bank targets might be difficult over the medium term.

Cushioned landing?

A soft landing is still possible given corporate and household resilience. When we look at expectations in the equity market, the news is not terrible. Aggregate revisions to earnings outlooks for the next 12 months have been positive recently. The last three years have seen companies and households dealing with major events – lockdowns, the energy shock, and a huge tightening of monetary conditions. Inventory and spending management has become more prudent as a result. Digitalisation of more aspects of economic life is underpinning investment spending and product development. It is true the Fed rarely engineers a soft landing, but you could argue it did in 1995 and 2018.

Waiting

The debate will not be settled any time soon. The lag between recession indicators (the start of the tightening cycle and the inversion of the yield curve) and the actual downturn in GDP can be long. A recession in early 2024 would not be out of line with historical relationships. For it to become more obvious, however, we need to see worse corporate news and a pickup in the unemployment rate. Until then, markets might be range bound with only technology stocks providing any real capital growth opportunities. That does not mean investor cannot make money. Short-duration fixed income looks attractive and there will be opportunities to gradually extend duration as we get closer to the first cut in rates.

Europe, far from rosy

For Europe, the European Central Bank (ECB) remains backward looking and hawkish. Parts of the Eurozone are already in technical recession. That could get worse if the central bank increases rates and squeezes liquidity. Bank funding costs will rise and lending conditions will tighten further. Some pressure on peripheral spreads may start to be seen in the months ahead, especially if the ECB moves to a more aggressive approach to balance sheet reduction. The early 2023 preference for European equities over US equities is not so evident today, despite the valuation attractions of the European equity market.

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