Hard landing delayed, risk-on
If the US economy avoids a hard landing, equities should continue to outperform bonds. History tells us it is normally only during periods of recession that there is meaningful and lasting equity underperformance. This is because corporate earnings decline as revenue growth slows and multiples recede. These are normally periods coinciding with central banks cutting interest rates aggressively. We are not in a recession. The US expanded at a quicker pace than expected in the second quarter (Q2). Forecasts are for earnings growth in 2024. Equity markets are up some 2%-3% in July after a 7%-9% total return in Q2. Credit spreads are stable. Bond yields remain in well-established ranges. The soft landing scenario is very much priced in and for the US at least, the data suggests it might be the softest of soft landings. The recession - if there is to be one - is delayed. Interest rates might have peaked but a long plateau could be ahead of us.
The peak (again)
Markets expect no more US rate hikes. The comments made to accompany the decision to raise the Fed Funds Rate to a range of 5.25% to 5.50% did not explicitly say the Federal Reserve’s (Fed) tightening cycle was over, but the insistence on future policy decisions being data-dependent suggest we are at the peak of the policy-rate cycle. Activity and inflation data would need to reverse their recent softening to get the Fed to conclude that more rate hikes are necessary. Importantly there was nothing to suggest the Fed sees any need to signal when it would start easing. It does not expect a recession in 2023 and remains wedded to the idea that the US economy will experience a soft landing. As discussed last week, that implies a period of below-trend growth which allows enough spare capacity to emerge to allow further declines in inflation. The release of Q3 GDP growth at an annualised rate of 2.4% suggests the economy is still growing close to trend. There was surprising strength in investment spending, which is good news for the medium-term outlook for the US economy. Consumer spending eased a little but remains positive.
Markets pricing soft
Market pricing is consistent with a soft landing. Taking the rates markets first, at the time of writing the implied end-year level for the Fed Funds Rate was 5.38%, which is consistent with the target rate. For the end of 2024, the implied rate was 4.16%, which is consistent with a target range of 4.00%-4.25%, suggesting 125 basis points (bp) of easing next year. Most of that is expected to be backloaded and consistent with easing in GDP growth and inflation. If a recession were likely, more rate cuts would be priced in. If investors think a recession is the more likely outcome, then two-year yields at 4.9% look fair value.
Long-term rates relatively stable
Long-term interest rates are also consistent with the soft landing scenario. The market prices in an overnight interest rate of between 3.5% and 4.0% over the three-to-five-year horizon. That is above the long-term estimate of the Fed Funds Rate taken from June’s Federal Open Market Committee ‘dot plot’, which puts the rate at 2.5%. Market pricing suggests the Fed will not be able to take rates as low as Fed officials suggest from their own forecasts of the ‘equilibrium’ rate. Again, this is consistent with a soft landing with limited increases in the unemployment rate. With the 10-year Treasury rate continuing to trade in a 3.50%-4.00% range, there is little to get excited about in terms of being aggressively overweight duration. If there is going to be yield curve dis-inversion, it is more likely to come from short rates coming down rather than any big moves in longer-term yields.
Bank of Japan boosts yields
In the short term, yields can continue to be volatile within the prescribed range. The better-than-expected Q2 GDP data and the decision by the Bank of Japan (BoJ) to allow more flexibility in its yield curve control (YCC) policy, pushed the global level of yields up towards the end of the week. Japan’s change in policy is modest but it is symbolic considering how long the BoJ has been prepared to make unlimited purchases of government bonds at yields of 0.5%, effectively capping market levels. That purchase level threshold has increased to 1.0%, allowing for the Japanese yield curve to steepen and marginally shift the attractiveness of Japanese government bonds slightly, relative to overseas bond markets (for Japanese investors). It is not clear whether the BoJ will make any further policy adjustments – it kept its lending rate at -0.1% and markets do not expect any change in the near future.
On the credit side the story is the same. Credit spreads remain stable. In fact, they have trended tighter in 2023, at least following the mini-banking sector crisis in March. This is true for both investment-grade and high-yield markets, in both the US and the Eurozone. While there are always idiosyncratic stories and there are starting to be some concerns about rising net interest burdens, overall credit metrics remain supportive. The fact that markets are not demanding a higher risk premium for lending to the corporate sector is also consistent with the major economies avoiding a significant recession.
Positive expectations for equities
Given how the fixed income market is set up and the implied macro scenario from current rates and credit pricing, it should not be surprising to see the equity market also trading consistently with a soft landing outcome. In the US, the current expected growth in earnings per share for the S&P 500 for 2024 (based on IBES consensus expectations) is for 12% growth over 2023 outcomes. For the Euro Stoxx universe, the 2024 growth forecast is 7.7%. This is not what normally happens in a recession. History shows that earnings fall and equity multiples contract, leading to an underperformance of equities relative to bonds.
Investors face a soft landing scenario, signalled by current market pricing and the economic data. If that continues to be the case, then US equities should continue to outperform fixed income and bond returns will remain close to that suggested by current yields levels. But outsized fixed income performance is unlikely given the limited scope that exists for yields to move significantly lower. Credit should outperform government bonds given the additional spread.
High beta credit
If the credit outlook remains benign, then there is no reason to think that investors cannot continue to see superior performance from assets like high yield, leveraged loans and emerging markets debt. Within the latter, valuations are attractive with spreads on benchmark emerging market debt indices remaining comfortably above 400bp and yields above 8%. This is similar to the implied returns from the US and European high-yield markets with the additional attraction of opportunities for more diversified performance in developing markets as countries emerge from the impact of the rise in global inflation and higher interest rates. Currency markets point to countries like Brazil and Mexico being in favour, with the latter benefitting from expectations of ongoing US corporate supply chain adjustments that could see more direct investment.
Again, the risk is of something worse
The hard landing is the alternative. It cannot be excluded and recent data from Europe has tended to support this outcome relative to the more resilient US economy. It is telling that multiples on European equities have not increased this year and European investment-grade credit has underperformed the US on a spread basis. Medium-term inflation expectations in Europe have risen relative to those in the US, and Europe remains more vulnerable to a repeat of the energy shock of 2021-2022. The European Central Bank (ECB) raised rates again this week, taking the deposit rate to 3.75% and this has not dampened expectations that it could go higher still in September. This came after further evidence of credit tightening in Europe with banks continuing to tighten lending standards to both households and businesses. The ECB seems determined to drive aggregate demand lower to get inflation back towards target. There has been progress. Eurozone inflation has fallen from over 10% last October to 5.5% in June. But the target is 2% or less. This means that large parts of the Eurozone economy may have to go into recession to get the average inflation rate down by another 3% or more. Headline inflation is still well above 6% in Germany and over 5% in France.
If there can be a scenario of a hard landing in Europe and a softer outcome in the US, then it suggests US equities and European fixed income would outperform. It would also be a scenario of renewed US dollar strength. It would be unusual but reflective of the more rapid the US has been in dealing with the inflation shock as well as the underlying resilience of the US economy. Europe has not only been slower in raising rates but started from a more expansionary position of negative rates. It is also having to deal with shocks from energy prices, increased fiscal burdens around defence and the failure of Chinese demand to recover, which has been important for sectors like luxury goods, autos, and travel.
The less-discussed scenario is the US economy continues to grow strongly, with a healthy consumer and corporate spending driven by the need to invest in artificial intelligence and net zero targets. This scenario need not be inflationary either, particularly if the supply-side issues are addressed by investment in capacity – digitalisation, energy efficiency, further automation. There would be limited room for rate cuts in such an outcome, nor for declines in long-term bond yields, but this would make for a continuation of the equity bull market. This is the scenario that is consistent with 12% earnings growth in 2024. It would also be an interesting backdrop to next year’s Presidential election, with the Democrats having made America great again! Think about that over what remains of the summer.
(Performance data/data sources: Refinitiv Datastream, Bloomberg). Past performance should not be seen as a guide to future returns.