“Uncertainty is an uncomfortable position. But certainty is an absurd one.”
— Voltaire
No relief for equity markets in October…
There has been no relief for investors from the growing sell-off in equities in October so far; and credit has also now started to move. The explanation is simple: markets have been factoring in the reinforced commitment of the Fed to fight persistent high core inflation – considered ‘sticky’ in the market lingo – by keeping policy rates ‘higher for longer’. This is in response to the hawkish bent of recent statements by Fed officials and the unexpected resilience of US economic output, consumer spending, and labour markets. Indeed, just yesterday, this remarkable US vigour was further underlined by the release of the latest GDP growth print, which showed the economy expanding at a breathless +4.9% annualised rate in Q3! (And if you want to explore this and other macroeconomic topics in more detail, please see our Q4 Macro Outlook & Investment Strategy published with today’s letter).
Positive US economic data, and the Fed’s decision to double-down on its ‘higher for longer’ messaging, have caused expectations for US rates to shift up and out – and to ripple right along the Treasury yield curve. This has translated into big losses on long duration bonds – as well as on so-called ‘growth’ equities, both in the US and in Europe (where deteriorating fundamentals have also contributed to market declines). Growth equities carry substantial implicit duration given the high share of their present value tied to uncertain (and thus discounted) long-term earnings growth prospects – prospects that are assumed to be in even greater doubt now given the macroeconomic environment.
But we should not kid ourselves that growth equities are the only (or even the biggest) problem. Rising rates may create some relative value opportunities in equities, and US small- and mid-cap names (many of which are trading cheaply on already depressed earnings) are a case in point; but rotating the portfolio into cheaper pockets will not offset large losses at the index level if equity is simply out-of-favour as an asset class. Correlations among stocks are always high, and tend to rise as sell-offs deepen. This is why we have seen such broad and seemingly undifferentiated losses in October: the fairly expensive S&P 500 Index is down -3.5% and the very expensive tech-heavy NASDAQ Composite Index is down -4.7% (so far so good), but then the inexpensive and more US domestic economy-oriented Russell 2000 Index, which is trading at less than half of its five-year average P/E, is down -7.2%… c’est la vie!
Equity markets beyond the US have not fared much better, underscoring the tendency for the US market and US economy to set the weather globally, in finance. The Euro Stoxx 600 Index is down -3.2% so far for the month, the NIKKEI 225 Index is down -5.3%, and the MSCI Emerging Market Index is down -4.4%. To be sure, fundamentals in Europe are abysmal – the most recent raft of PMIs are the worst since the depths of the pandemic in 2020 – and the slump in China’s property sector is weighing on domestic demand and raises the very real risk of a financial crisis in the world’s second largest economy. But there is no doubt from where the present storm of selling originates.
Duration looks increasingly attractive; credit, not so much…
Spreads have finally started to widen in the US and Europe, reflecting a deteriorating credit outlook in both regions (albeit for different reasons). But they are close to historical averages, and thus likely still have some way to go. Throughout 2023 so far, capital has flowed into investment grade and high yield credit from institutional investors attracted by the highest all-in yields in decades. But as rates have risen, the spread component of these yields has represented an ever-diminishing share of the total, and the appeal of an extra 150-450bps over duration-equivalent government bonds has fallen. This is especially true at a time when global growth is slowing, and the Fed has committed to keep US rates ‘higher for longer’ to beat inflation. High rates held high for an extended period will mean more balance sheet stress for over-leveraged firms and worse odds that the Fed intervenes to boost bond market liquidity if rising defaults suddenly spook the market. This is bad news for credit; so, too, is the risk of a recession in Europe or a financial crisis or more profound slowdown in China, for that matter. Still, there are pockets of global credit that sustained large losses earlier in the year and where spreads do offer reasonable value; notably, financial credit. And others where strong selection can unearth hidden gems. This is where we have focused.
At the same time that credit’s star is falling, however, duration’s star is rising. As US rate expectations have shifted out and up, and the yield curve has steepened (or un-inverted, take your pick), the appeal of locking in those high rates by buying longer duration Treasuries has grown. The Fed may be beating the hawkish drum, but this concerns the persistence of high rates (rather than the levels) and the odds of further hikes in the New Year and beyond are negligible. This makes a 5.2% yield on 20Y bonds that would also be highly sensitive to any cuts (when they come) a no-brainer: the asymmetry in expected payoff is huge, the interim carry is high, and the diversification benefits likely strong.
A war in Gaza could engulf the region and push up oil prices… but this is not our base case.
The immediate market reaction to Hamas’ devastating attack and the looming war with Israel was fairly muted: oil and safe havens enjoyed limited rallies, but these moves soon subsided as worries about US rates took centre stage once more. Nevertheless, the situation could change once the ground invasion of Gaza begins (as expected); and, particularly if Iranian proxies such as Hezbollah open up a second kinetic front on Israel’s northern border. In terms of scenarios, the most troubling for markets would be if Iran were to get directly militarily involved or if it were to blockade oil trade in the Strait of Hormuz. But these high market impact scenarios have lower probabilities – particularly at the outset of the war, when there is limited visibility on how successfully, or long, it will be fought. Given the low cost alternative that is available to Iran – having other motivated groups fight on your behalf – our base case is for the market impact from the war to be contained in the short-term. But the risk of a sudden escalation will hang over Middle East oil markets for months, if not years, to come. This points to the hedging benefits of holding both gold and energy (or related stocks) in portfolios.
If you have any questions about the themes discussed in this article, please do not hesitate to get in contact with us: info@bedrockgroup.ch
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