Having experienced substantial volatility in mid-March following the failure of Silicon Valley Bank (‘SVB’) and the emergency acquisition of Credit Suisse by UBS, markets have since stabilised; indeed, a broad rally has taken place across equities, credit, rates, and commodities, as expectations for US monetary policy have moderated and the threat of a wider crisis subsided thanks to generous liquidity guarantees from central banks. However, the trauma will be with us for some time to come – largely in the form of materially tighter lending standards; and this trauma may well precipitate a recession in the US (and perhaps Europe, too) if there is a credit crunch in the second half of 2023… and central banks fail to act. Nevertheless, the immediate financial instability has been contained, in no small part thanks to the rapid policy response (albeit likely with negative long-term consequences for market functioning given the further entrenchment of already rampant moral hazard). Moreover, despite the, at times, hysterical forecasts for rates in the immediate wake of SVB’s failure – for example, Nomura analysts predicted cuts to the Fed Funds before the end of the month – the ructions did not prevent policymakers at the Fed and ECB from hiking their respective policy rates by 25bps and 50bps when they did in fact sit down towards month-end. This helped to restore a sense of normality and reminded investors that, with inflation still running hot, monetary policy cannot change on a dime…
Anyway, in the fast-moving world of 2023, all this is already ancient history; and the key question for us is where markets go from here. For the most part, investors seem divided and highly uncertain in their outlooks. In particular, two narratives about the state of the global macroeconomy, and thus investment fundamentals, are competing for attention and thus for supremacy as drivers of market prices. Both are fairly well-supported, at least by a selective reading of the data; and, confusingly, each may be used to support either a bullish or a bearish forecast for asset prices (or pockets thereof)… subject to small tweaks, and changes of emphasis. The result is a schizophrenic market that is hard to predict in the short-term, as many macro hedge funds have found out the hard way in recent weeks. Still, we have to take the world as it is – not as we would like it to be!
The first competing narrative about the global macroeconomy goes something like this. Most data from developed markets – particularly the hard data, which is less sensitive to doom-laden headlines about the soaring price of butter, the Ukraine-Russia grain deal, or job losses at Meta – show that economic growth has remained remarkably resilient in recent months, despite the pace of rate hikes. US GDP grew at an annualised rate of +3.2% QoQ in Q3 last year and at +2.7% in Q4, while the St Louis Fed’s nowcasting model estimates that the figure for Q1 of this year is +2.2% (i.e., hardly recessionary). Meanwhile, Eurozone growth may have flatlined in the winter but Markit Composite PMIs for January, February, and March came in at 50.3, 52.0, and 53.7, respectively. This suggests that economic growth is gathering pace, not going into reverse. (The March Composite PMI for the US, at 52.3, is the highest reading since June 2022.) Meanwhile, there has been much talk of the ‘cost of living crisis’ in the US and Europe. But, while household bills have indeed increased meaningfully in recent months, prudent energy policy and a bit of luck for Europe have helped to keep these costs contained and consumers (many of whom had excess savings from lockdown) have continued to spend at a decent clip. Of course, this better-than-expected consumer spending outcome was only possible because almost anyone who wants to work, can work: unemployment in the US just fell to 3.5% in March as another +236K jobs were added and the participation rate climbed to a post-covid-19 high of 62.6%. In fact, the US and European economies are so robust – and the labour markets so tight – that companies are struggling to fill jobs without offering generous pay packages. This is why central banks continue to highlight the risk of spiralling inflation and the need to stay the course on policy. The Fed and the ECB are looking at the same data that we are, and they know that the economy can (and must) take more monetary tightening. Higher rates are resulting in localised stresses in already-vulnerable markets like US and European commercial real estate, already battered by post-covid-19 work patterns, or the most speculative forms of venture capital, which had become a kind of Ponzi scheme dependent on ‘greater fool’ investing enabled by near-limitless QE. But a bit of creative destruction is capitalism at work, and does not represent a danger to broader growth. Finally, the positive economic picture is not about to come to an end. China’s goliath economy is just beginning to rebound from the end of ‘Zero Covid’ late last year, and we can expect substantially more demand for goods (particularly commodities, the prices of which have once more started to rise) as the year progresses. This is set to help emerging economies in particular. But Europe, too, should benefit from an improvement in China’s economic health. And while the Fed and the ECB are committed to limited further rate hikes, as necessary, the strong backdrop makes a soft landing – or no landing – far more likely.
The second, bearish, narrative takes a different tack. Although the headline economic growth figures suggest some resilience to higher rates so far, this cannot last; indeed, it must not. Higher policy rates are being implemented to materially cool demand and the economy because this is the only way to get a grip on dangerously high and potentially sticky inflation in the US and Europe. The fact that, even with policy rates rising at a record pace (against a backdrop of record indebtedness, do not forget), workers in the US and Europe have managed to negotiate bumper pay deals is a slap in the face for the ECB and the Fed. Indeed, it suggests that policymakers will need to keep policy rates higher for longer than these economies can safely handle in order to correct the behaviour of workers (a stance that has been repeatedly hinted at by officials). Also, labour market tightness is in large part a function of post-covid-19 work patterns that are harmful to economic growth, such as increased part-timing and early retirement and limited immigration of cheap(er) labour during the pandemic. If the labour pool has indeed shrunk and become more expensive, you cannot sustainably produce the same level of output now as you did in the past without substantial business investment and large productivity gains (which have not happened and will be constrained by higher rates too going forward). To be sure, the most recent US CPI data, released this week, showed headline inflation falling to just +5.0% YoY (the lowest level since 2021). But this was entirely due to falling energy prices (which are, incidentally, now going back up following the announcement of OPEC+ production cuts from May and with the re-integration of a re-bounding China into the global economy following the end of ‘Zero Covid’). US core CPI stood at +5.6% YoY in March vs. +5.6% in January and +5.7% in December. This means that there has been no progress whatsoever in taming core inflation in 2023 despite energy prices having fallen off a cliff (a fact that prompted hawkish statements from Fed policymakers this week). Even more disturbing is the Eurozone core inflation print for March at +5.7% YoY, the highest reading yet. Core inflation had hit +5.0% YoY in Q4 last year when rates were 100bps lower than today and GDP growth was at a standstill… how is that a picture of health? Finally, the consumer may have had savings to draw down on during the immediate post-lockdown period as a means to stabilise spending under extreme cost of living pressures, but those savings have rapidly depleted. That is why retail sales in the US just fell -1.0% in March (and have been lacklustre for months). Once rates have begun to bite into empty pockets and the lagged effects of tighter monetary policy, on housing, for example, begin to show, the economic good times will come to an end; and they may do so very fast if higher rates precipitate further bank failures or a wave of defaults amid a credit crunch (a real threat post-SVB). The question is, in such a scenario, how much space will central banks have to respond – and will they notice in time?
For asset prices, an environment in which rates move higher and stay higher because a strong economy allows – indeed, necessitates – hawkish central banks to prevent inflation from becoming embedded, is markedly different from one where the same policy is implemented against a stagflationary backdrop because the alternative (i.e., not gripping inflation) would be even worse long-term. In the former case, risk assets (particularly value equities and high yield credit) are likely to perform well, particularly once the monetary policy stance is shown to bring core inflation down. But long duration fixed income and liquidity-driven assets (such as growth equities and cryptocurrencies) are likely to lag. In the stagflation case, it all depends on when the central banks can revert to easing policy. If fundamentals deteriorate and liquidity narrows sharply at the same time, there would likely be nowhere to hide beyond the dollar. But a harsh credit environment, a softening of labour markets, and a collapse of commodity prices due to recession would eventually become its own cure, allowing inflation and rates to fall. If central banks can pivot faster in the event of a ‘hard landing’ of this kind, assets like gold and government bonds would likely be beneficial to portfolios.
Our view is that the economy is deteriorating, the tussle between central banks and inflation has yet to conclude decisively in favour of policymakers (which suggests rates have further to rise and then longer to hover at painful levels), and that valuations do not reflect the scale of downside risks to the outlook, as a result. We therefore favour an allocation to gold (which has blown through all-time highs this week, rising >2000$/oz), and a barbell approach in fixed income (with a mix of long-duration treasuries as a hedge against recession without taking risk in the overbought belly of the curve, and short-duration treasuries to maximise yield at minimal risk). We also favour emerging market equities to capitalise on commodity and positive China-related developments and a diversification of developed market equity styles to avoid overcommitment to any one plausible future in the highest risk asset class. With this mix we feel well set-up for the future. But stand ready to adjust positioning tactically as narratives jostle for supremacy in the coming weeks (and, potentially, new ones emerge).
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