Investment Institute
La Versione di Iggo

Don’t give up on us baby!

  • 15 Marzo 2024 (7 min di lettura)

No way Hutch. The lower inflation gets, the easier it is for rogue numbers to upset the narrative. We are now in that phase and recent US inflation reports illustrate this. The big picture, however, is that inflation is lower and is consistent with a soft landing scenario. In the US, growth has not slowed by as much as expected and inflation is a little sticky. That’s okay though. The risk of rates moving higher is limited. The chances of rates not being cut by as much as they could be is being well flagged (even if sell-side forecasts are more aggressive). Investors like stable credit yields and the implied carry that brings to fixed income portfolios. And if economic growth is better, then the equity return foundations are also better. The macro environment remains supportive for investment-grade credit, high-beta credit and growth equities.

The only way is up 

This is a bull market characterised by strong momentum and rising valuations. It is most obvious in US growth equities, high yield and high-beta credit, and crypto-related assets. The macro narrative supporting this market is that a US soft landing is the most likely scenario relative to a hard landing or no landing at all. It is all about the US. Europe is struggling to avoid stagflation and China is fighting a renewed round of deflation. Global market sentiment and behaviour is driven by what is happening in the US. With an election looming, that will continue to be the case for the rest of 2024.

Soft landing 

The soft landing narrative supposes growth is slowing enough to allow spare capacity to emerge, thereby allowing inflation to return to the Federal Reserve’s (Fed) target level of 2.0%. Important markers are the modest rise in unemployment – 3.9% in February compared to the 3.4% low at the beginning of 2023 – and the slowing of inflation rates. This week’s important data point was the March consumer prices report, showing the core year-on-year rate slowing to 3.8% from 3.9% in January, and down from 5.5% in February last year and 6.4% in 2022. Shorter-term measures of inflation momentum suggest there is some room to go before the Fed can declare victory over inflation. So, it will wait until it cuts interest rates, while subtly suggesting to the market that rate cuts are coming.

The market gets the message, with interest rate expectations more stable in recent weeks. The current state of the economy means the Fed does not want, or need, to cut rates aggressively. Some sell-side forecasts are looking for more cuts than currently priced in – and this is especially the case for forecasts of the European Central Bank’s (ECB) policy rate - which points them towards a “harder landing” scenario. (This might just reflect the conditioning of expectations of monetary policy responses that were forged in the era of unconventional monetary policy). Current pricing puts a 60% chance of a rate cut in June and a total of 100 basis points’ (bp) worth of reductions in the Fed Funds Rate by year-end. It is a similar picture for the ECB.

Hard landing 

A hard landing scenario would imply much weaker growth data in the months ahead, disinflation, a more pronounced rise in the unemployment rate and a decline in corporate profits. Rates would be cut more aggressively in this scenario and financial markets would respond in a typical ‘recessionary’ way with risk premiums rising on equities and credit, and bond yield curves steepening rapidly. There is a risk of this scenario, but even the more challenged parts of the world have avoided a hard recession – Europe and the UK have flat growth profiles and China is set to make 5% growth again this year. The chances of a hard landing in the US need either a shock or a meaningful change in the monetary policy outlook.

No landing 

A no-landing scenario is where growth does not slow enough to allow spare capacity to emerge, or residual inflationary pressures to ease. The stickiness in service sector inflation together with growth close to trend might tilt the Fed towards keeping rates higher for longer. Some market commentators have publicly argued that the Fed will not cut interest rates at all this year. While a hike in rates is a very low probability outcome, financial conditions could tighten if rate expectations reflect no change. A no-landing scenario which avoids ending in higher inflation and more tightening would be nothing short of an economic miracle and depends entirely on a US productivity surge. There is a lot of hope that artificial intelligence (AI) can boost productivity, but it is probably too early for it to bend the laws of economics that much.

Reset and carry 

The soft landing core scenario is turning out to be bullish for markets. Rates are expected to be cut, globally (except in Japan), and if a recession is avoided then risk assets can continue to perform. What we observe now is that the current scenario is very positive for credit. Valuations adjusted to higher rates in 2022-2023 and return expectations are now positive. Investment-grade credit is fundamentally sound and provides an income stream that can be used to match liabilities more effectively than when yields were very low. Total returns from investment grade have been flat year to date but this reflects the backup in interest rate expectations in January. Total returns are positive since mid-February and income returns, for US investment-grade credit for example, are running at about 50bp per month, and 20-25bp in euro credit. Carry is an attractive return in a soft landing scenario and total returns will be boosted when rate cuts come.

Credit beta and short duration 

It is also a good time for high beta credit. Stable rates and the short-duration nature of alternative credit mean most of the return is coming from attractive spread and floating rate returns linked to cash, which is stable for now. Some credit beta assets were cheap too. So, things like Asian high yield, CCC-rated US sub-investment grade, leverage loans and emerging market credit have performed very well this year, as well as the more cash-like assets such as floating rate asset-backed securities. Leverage does not seem to be an issue. Anecdotally, private debt and equity flows continue to be a huge support for capital structures that are leveraged and, in other cycles, may have been compromised by the monetary tightening seen over the last two years. More generically, the soft landing means yield curves remain inverted for longer, which supports short-duration bond strategies over longer-duration bets.

Growth stocks 

Equities are also a beneficiary. Performance in the US equity market has been concentrated – one-year total returns for the information technology (IT) and communication services sectors was 58% for both to 12 March. Yet the industrials, financials and consumer discretionary sectors have all posted double-digit total returns. Regionally, only China, related Asian markets and the UK have disappointed. Within the winners it has been all about growth and technology stands out. According to Bloomberg data based on company earnings reports, the aggregate profit margin for the IT sector stands at 24% versus an S&P 500 index average of 12%. It’s a sector with little debt, enjoying a product revolution, strong earnings growth and a significant amount of cash on collective balance sheets (18% of total assets). Higher rates have not really hurt, and lower rates will boost overall economic confidence, sustaining the trends towards greater US corporate investment on technology.

Nothing last forever 

No scenario will last for ever. A no-landing would eventually become a hard landing because financial conditions would be tighter for longer. A soft landing will come to an end because of concerns over exuberance, renewed leverage growth, profit dilution or fiscal problems. Hard landings don’t last because central banks lower rates, asset classes become cheap and business models are reset. But for now, the soft landing backdrop looks set to be in place until at least the US election later this year. There is maybe also a psychological reinforcement when it comes to the political outlook – the economy and markets are good which means no need to rock the boat and re-elect Donald Trump, which is good for markets.

Rates bulls want a hard landing because that will boost returns from duration and yield curve steepening strategies. They are not getting it now. I would argue that if rates bulls are eventually right and central banks ease aggressively, they will be doing so because not only will inflation be back at target, but growth will be weak and that will bring stresses for corporate balance sheets and cashflows. In other words, what is good for rates is not likely to be good for credit and equities. The data might eventually provide that long-duration and short-risk opportunity. But not for the now.

Bull but not bubble 

Momentum and valuations are front and centre. Markets are showing strong momentum, and mentions of “bubble” are on the rise. Most risk assets are performing well – credit spreads, including European peripheral debt spreads, have narrowed. Equities are delivering strong returns. Gold and bitcoin are up in price. Yet there is no overwhelming sense of euphoria (away from Nvidia and selected AI-related stocks) or a sense that leverage is being ramped up to generate even stronger investment returns. Some of that may be happening but markets in general are not in a bubble. But investors do need to watch valuations. I mentioned recently that US credit spreads are near the tightest of the last 10 years. But the technical state of the credit markets is very strong – good issuance, healthy demand and, in high yield, strong reinvestment flows from coupons and redemptions. Equity price earnings are high in the US but that is biased by the IT sector. Moreover, earnings growth expectations have started to tick higher again, perhaps encouraged by signs that the global manufacturing and trade cycle has bottomed out. The US industrials sector is trading on 18.5 times 2025 expected earnings per share, reflecting optimism that earnings growth can recover after a couple of flat years.

Nevertheless, risk assets have had a good run since last October. Using a very simple indicator, momentum for the S&P 500 is at about as good as it gets and either some slowdown in upward price momentum is ahead (which means more short-term volatility in equity prices) or a reversal of some kind is coming. Rates momentum is neutral on the same measure but any weakness in the data could give this market a push, meaning more bullish moves in short-term rate expectations and bond yields.  But if the soft landing scenario is maintained, I would expect any setback in risk assets to be bought and the positive momentum to become broader – even UK equities might find a bid! There are plenty more boxes to tick before this becomes a full-blown irrational exuberance market.

(Performance data/data sources: Refinitiv DataStream, Bloomberg, as of 14 March 2024, unless otherwise stated). Past performance should not be seen as a guide to future returns.

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