All Eyes on The Fed

September 13, 2023

Monthly View 

In August both equity and bond markets took a step back because of better-than-expected economic data in the U.S. Why? Because the market is now more concerned about the economy running hot rather than a recession. And if a strong economy leads to a rebound in inflation, the fear is that the Fed could keep raising rates.

Despite negative markets in August, we have not changed our view. The U.S. economy is still in a sort of goldilocks scenario, which should be supportive of equity markets.

The U.S. economy is clearly doing well at the moment. Profit margins remain strong with second quarter estimates showing a rebound for non-financial firms. We fully expect companies to do more of what is working, driving growth by increasing capital expenditure. While the consensus remains focused on the consumer and jobs, we believe it will be firms’ desire to increase capacity to meet already solid demand that drives growth in the next year. Capex spending could provide a boost to real GDP growth.

Combined with inflation cooling further, partly because of the deflationary effect of falling prices in China, the U.S. economy is still in a good position and stocks should resume their rally in the near term.

More recently, the dominant market opinion seems to argue that the U.S. economy not only has weathered the Fed’s rate tightening cycle successfully, but is also set to accelerate. That narrative is supported by the Atlanta Fed’s GDPNow model, which is currently forecasting an eye-popping 5.6% annualized growth in Q3.

While market participants acknowledge that global economic growth outside the U.S. is weak, it has not been able to derail the U.S. expansion. In fact, weak global growth may even aid the Fed and other developed market central banks in achieving their inflation targets. Thus, a strong U.S. and a weak global economy might even help accomplish a soft landing in the U.S.

The Fear of Higher Rates

As mentioned, the recent market weakness is driven by fear that the U.S. economy is too strong. That sounds counter-intuitive but the main driver here is the fear that the Fed will keep raising rates.

Chair Powell made it clear that the path forward will be data dependent, which means it is still possible we see further rate hikes later in the year if economic growth surprises to the upside or inflation reaccelerates.

Presently, the Fed seems to be paying a lot of attention to the strength of the jobs market, which seems to be leading the current interest rate curve forecast. The labor market is still strong and only softening slightly, with wage inflation also coming in lower than expected.

On the surface, this dynamic is positive for the economy and risk assets as it suggests that inflationary pressures are continuing to ease without causing a significant deterioration in the economy. However, the outlook is concerning. The full impact of the Fed’s tightening cycle has not yet been transmitted to the economy. Unless the Fed makes a pivot to meaningful rate cuts prior to an economic recession, the labor market will continue deteriorating and the unemployment rate will eventually rise to recessionary levels.

In the meantime, the ongoing softening of the jobs market and easing price pressures raise the odds that the Fed does not hike again this year. This should support investor sentiment at least in the next few months. Especially as it seems that inflation and labor costs are basically rising in line with each other, maintaining business margins and profits.

Rather than waiting for the next recession, we believe investors should accept that the U.S. is still growing above trend. Meanwhile, it is exporting growth to the rest of the world through a widening trade deficit, which is now allowing Europe and China to improve their economic prospect through inflation-killing monetary policy in the EU and fiscal stimulus in China. The global outlook for the next twelve to eighteen months looks arguably better than many investors expect and consensus realization of that should come soon. September and October are historically volatile months but not always negative. Historically, October has been a positive month – in fact it has been marginally more positive than September has been negative.

China’s Role in the Global Economy

Currently, deflation in China is helping the U.S. to maintain its goldilocks scenario of strong GDP growth, strong jobs markets and falling inflation.

As we expect to see increased capital investment, the global economy could be on the cusp of an upcycle in manufacturing, which will bring more supply and disinflation to world markets. This month’s ISM data reported improved readings in all three economic regions, as they bottomed after a long post-COVID retreat due to consumers’ shift to service consumption.

The upturn is being led by China. While the official headline ISM for China was still below 50, the new orders sub-component broke above. Moreover, the Caixin China General Manufacturing PMI, which tells more about the private sector, jumped to 51.0 from 49.2.

Western press has been overly negative on China, partly reflecting a domestic bias. However, there are signs that China’s economy is improving in response to growing stimulus.

We also have to realise that the real estate downturn and the liquidity crisis among property developers is mostly a domestic problem and will not necessarily affect China’s trade. Nevertheless, the liquidity crisis in the property sector hurts domestic investor sentiment. The government is actively introducing several measures aimed at reviving the property sector to avoid a crisis of confidence. However, so far only in small steps.

As we mentioned last month, one of the problems in China is that the household savings rate is very high. The reason is that people want to save for their retirement, their healthcare and the education of their children.

China probably already has a confidence crisis, so if the Chinese government would stimulate by giving money to households directly like the U.S. and Europe have done, it would probably only lead to more savings.

In our view, China’s government should invest a lot more to offset the household savings and could for example invest in healthcare and education. This would have long-term positive effects for the Chinese economy. Secondly, it will give people more confidence in their future, which might mean they will invest in companies rather than saving accounts, which is what a dynamic capital market needs.

Industrial Policies are Supportive for New Technologies

The recent policies in the U.S. favor manufacturers of semiconductor chips and electric vehicles to the detriment of the more traditional parts of the economy.

This is precisely the same policy that President Xi is following in China. In reaction to U.S. sanctions, China has allocated billions into chip development, electric vehicles and alternative energy technologies. Moreover, after years of overinvesting in residential development as the core driver of expansion, China is trying to restructure the property sector including the unwinding of debt, often hidden in wealth management products.

The underperformance of Chinese assets over the past several years, especially relative to their global peers, has likely already reflected widespread pessimism. It is interesting to note that Chinese stocks have stopped underperforming in recent weeks amid the intensifying doom and gloom. Although the growth outlook for China is not great, equity valuations are pricing in a lot of bad news already.

Emerging Markets are Ready for Rebound

If we look at the broader emerging markets space, then 2023 so far can best be described as yet another year of developed markets dominance over emerging markets. Year-to-date, emerging market equities are up only +4% vs +15% for developed markets, as measured by the MSCI Emerging Markets and World Indices. The pattern holds true for the last 10 years (+3% vs +9% per year) as well.

While this decade has started much the same way, there are several reasons to think the trend may not last. First, Emerging Markets (commonly abbreviated as EM) are drastically under-represented in equity markets. While EM makes up only 20% of global equity market cap, these markets contribute circa 50% of global GDP in USD terms and 60% in purchasing power parity terms. They hold 55% of global FX reserves and are responsible for 60% of global energy consumption and 80% of global oil production. Most importantly for the very long term, EM accounts for 80% of land area and 90% of the human population. In other words, emerging markets are too big to ignore.

Current market valuations and positioning tell a compelling tactical story. At the end of August, developed markets had a forward PE of 17x vs 12x for emerging markets. Though EM typically trades at a discount, it remains at stretched levels and offers an interesting entry point. In addition, positioning is extremely light as most investors have exited EM over the last 6-9 months, either due to geopolitical reasons or due to fear of missing out on the U.S. rally. As a result, there are few sellers of EM left, creating a sizable gain scenario in EM vs DM equities should the consensus change.

Oil at $90

2023 has proven to be a volatile year for energy markets. By the mid-year mark the price for U.S. crude had fallen to $68, nearly 45% below its 2022 peak. Recently, spurred by record high demand and better-than-expected economic growth, crude prices have rallied over 20% from their June lows.

Recent volatility has caught many investors off guard and wondering: what is driving these markets? Many attribute oil’s poor 1H23 performance to recession fears and a weakened Chinese economy resulting in low demand. However, that narrative is not fully supported by the data. Global oil demand reached an all-time high of 103mb/d in June, driven by an uptick in demand for mobility fuels (gasoline, diesel, jet fuel) as well as surging oil consumption in China. While rising consumption has lifted the price of oil, the same is true for falling supply. Global oil supply fell by 910kb/d to 100.9 million barrels per day in July, driven by significant production cuts from Saudi Arabia and other OPEC+ countries, marking the lowest production levels since October 2021.

In the short term, we expect energy prices to remain volatile given the possibility of economic disappointment in China. Lower growth expectations from China, and possibly the U.S. will quell energy demand going forward. But from a long-term perspective we remain positive on energy. We believe demand for oil will remain high in the medium-term as the transition to green energy will take decades, not years. Additionally, material underinvestment in the sector will lead to long-term supply constraints that will bolster energy prices.

Time to Buy Longer Dated Bonds

Long maturity Treasury yields surged higher in the past month due to concerns over increased auction sizes, a credit downgrade by Fitch for U.S. government debt and the bond market pricing out the possibility of an imminent U.S. recession. The bear market in Treasuries has been driven by a surge in real yields, while inflation expectations have remained well-anchored –  the 10-year inflation breakeven rate (2.36%) is largely consistent with the Fed’s 2% target. Presently, the U.S. 10 Year Treasury is yielding 4.28%. In conjunction with falling inflation expectations, the 10 Year long-term real rate is now at 1.92%, marking its highest level since 2009.

We believe high real yields are at sufficiently restrictive levels to impact the real economy. The constraining stance of U.S. monetary policy is substantiated by the deeply inverted yield curve, the contraction in the money supply, and the tightening of credit conditions. Consequently, the high real yields already reflect peak Fed hawkishness. As we approach the end of the Fed’s tightening cycle the landscape is becoming increasingly appealing in terms of extending the duration or interest rate sensitivity in fixed income portfolios. From an asset allocation perspective, the bond risk-adjusted return profile has improved relative to stocks.

The bulk of the investor community has now embraced a ‘soft-landing’ or ‘no-landing’ scenario for the U.S. economy. However, a weaker 2024 U.S. economic growth scenario is plausible as U.S. household excess savings deplete, the U.S. fiscal thrust wanes and the lags of monetary policy impact the credit cycle. Consequently, a backdrop of low inflation will likely drive expectations of a shift toward easier Fed policy. Therefore, signposts for a mild 2024 U.S. recession and a labor market cycle suggest more aggressive rate cuts than currently factored by the bond market.

Investors remain very bearish on bonds, with stretched short positioning. This can potentially serve as a catalyst for a bond rally as we look ahead into 2024. Lastly, tightening credit conditions pose a headwind for corporate credit and, on the margin, we expect fixed income investors to lean on sovereign debt for relative safety.

Portfolio Changes

During August, we decided to make a number of changes to our core ETF portfolios. We took profits on recent winners after strong performance this year and reallocated to underperforming exposures. This meant decreasing allocations to US Tech and Japan and increasing allocations to Financials, Commodities and China.

We remain positive on both U.S. Tech and Japan exposures but prudent risk management requires position size control and both exposures have performed well over the last 12 months.

Financials have underperformed during the first half of the year, but the big banks and insurers have spent the last 18 months preparing their balance sheets for the coming recession and thus we believe are poised to do well over the coming quarters. Especially since in our view a recession in the next 6 months is unlikely. 

Given our view that a potential recession is still some time away, we also topped up Commodities. There has been chronic undersupply in the commodity and energy complex and continued actions by OPEC in oil and gas production will provide a floor for the oil price.

Lastly, though China’s issues are well telegraphed, there is a steady drumbeat of targeted government action that will take a few months to be felt, but is without question there. Lower rates, no more tech regulatory crackdown, easier mortgage rules, central government financing for local entities, etc. Cheap valuations, weak positioning and ongoing government efforts are likely to support Chinese equities going forward.

Within Fixed Income, we cut China government bond exposure to take profit on the rate rally seen in that market over the last few years. When we first allocated to Chinese government bonds 10-year rates were 4%+ but today hover around 2.5%.

We also reduced international bond exposure given that a large portion is in Japanese bonds. Japan remains the only market yet to raise rates. The cash was used to increase U.S. duration via the purchase of long-dated treasuries as we believe we are at the end of the Fed hiking cycle. 30 year rates were at 4.5%, a post GFC high, when we began the rebalance, allowing us to increase duration at an opportune time. We are now broadly neutral duration for the first time in 3+ years. While there may be short term upside pressure on rates, over the medium term we expect a slowdown in the U.S. economy to lead to lower rates, thus benefiting our increased duration positioning.

DISCLAIMERS & DEFINITIONS

This material represents an assessment of the market and economic environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results.

Forward-looking statements are subject to certain risks and uncertainties. Actual results, performance, or achievements may differ materially from those expressed or implied. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Past performance does not guarantee future results.

The MSCI Emerging Markets Index is a float-adjusted market capitalization index that consists of indices in 21 emerging economies: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey.

Investments in emerging markets may be more volatile and less liquid than investing in developed markets and may involve exposure to economic structures that are generally less diverse and mature and to political systems which have less stability than those of more developed countries.

Investments in commodities may have greater volatility than investments in traditional securities, particularly if the instruments involve leverage. The value of commodity-linked derivative instruments may be affected by changes in overall market movements, commodity index volatility, changes in interest rates or factors affecting a particular industry or commodity, such as drought, floods, weather, livestock disease, embargoes, tariffs and international economic, political and regulatory developments. Use of leveraged commodity-linked derivatives creates an opportunity for increased return but, at the same time, creates the possibility for greater loss.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks, including changes in credit quality, liquidity, prepayments, and other factors. REIT risks include changes in real estate values and property taxes, interest rates, cash flow of underlying real estate assets, supply and demand, and the management skill and creditworthiness of the issuer.

Exchange Traded Funds (ETF’s) are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the investment company, can be obtained from the Fund Company or your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.

Rebalancing/reallocating can entail transaction costs and tax consequences that should be considered when determining a rebalancing/reallocation strategy. Neither Asset Allocation nor Diversification guarantee a profit or protect against a loss in a declining market. They are methods used to help manage investment risk.

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