The End of Rate Hikes in Sight
May 9, 2023
Global financial markets started the second quarter on a positive note. European stocks were at the forefront of the global equity rally with UK and Euro Area equities posting strong returns in April. Meanwhile, Chinese investable and domestic stocks were in the red, dragging down the emerging markets equity benchmark. The British pound and euro gained 1.9% and 1.6% vis-à-vis the U.S. dollar, respectively, boosting the performance of UK and Euro Area equities in U.S. dollar terms.
Gold and silver have been performing well recently partly driven by falling real yields in the fixed income market but also driven by heightened geopolitical tensions, and the continued regional bank crisis in the U.S.
So far this year, economic growth has been positive, as we expected, but we are now starting to see a slowdown in economic activity across the board. Whether this means that a recession is around the corner is the big question. Our view is that a recession is still not imminent. Normally investors would want to be cautious investing in risk assets when recession risks are rising. However, in the past 15 months we have already experienced an equity bear market while we did not experience a recession. At the same time investor sentiment is still quite negative.
Our view remains that U.S. inflation is likely to fall significantly during the rest of the year, even as the unemployment rate remains near record-low levels. Equity investors will applaud this outcome because the market will get more positive about a potential soft landing. Unfortunately, such optimism is probably misplaced, as a soft-landing is something we never experienced, and we probably don’t even know what it means. But it does mean that with inflation pressure abating and the job market holding up, we could see a positive rerating of the equity market in the coming months.
Another One Bites the Dust
First Republic was the next mid-size bank to be seized by the Federal Deposit Insurance Corporation (FDIC). JPMorgan emerged as the winner of a weekend auction for First Republic after regulators decided that time had run out on a private sector solution. JPMorgan is acquiring nearly all the deposits and most of the assets.
The crisis that led to the downfall of three regional U.S. banks in recent weeks is largely over after the resolution of First Republic, according to JPMorgan Chase CEO Jamie Dimon. Let’s hope Dimon is right that no other banks will fail but the stress on regional banks is real. Whether other banks fail or not, the real impact will be the credit contraction that will happen. Smaller banks have seen an outflow of deposits, which impacts their ability to lend to businesses and to provide real estate loans. This will have a slowing impact on the U.S. economy. This is also reflected in the much lower Treasury bond yields we have seen since the Silicon Valley Bank failed.
At the same time, these lower bond yields offset some of the negative impact on the economy and they also support equity valuations. This is the paradox we are facing in the coming 12 months. Although it is certainly possible that the U.S. and global economy slows into a recession, it is also possible that a lot is already discounted in financial asset prices.
The End of the Rate Hiking Cycle?
As expected, the Fed delivered another 25bps rate hike. However, the FOMC statement and Chair Jay Powell’s post-meeting remarks signaled that this increase may mark the end of the tightening cycle. Moreover, Powell revealed that while there was a strong consensus behind the 25bps increase, policymakers did discuss the possibility of pausing at the next meeting. Powell also indicated that over the past 6-7 weeks, the Fed has been focusing on the economic implications of credit tightening caused by the regional bank crisis.
That said, Powell noted that if inflation evolves according to the FOMC’s forecast, then rate cuts would not be appropriate in the second half of the year. He once again highlighted that core services ex-housing inflation has not yet rolled over.
Wage growth, which is viewed by the Fed as the most important driver of core services inflation ex-housing, has picked back up according to the Atlanta Fed’s wage growth tracker in both nominal and real terms. This acceleration in wages could prolong the recent pickup in services activity, forcing the Fed to resume raising interest rates, which are already in restrictive territory.
We think that would be a mistake.
The singular focus on inflation by the Fed is a risk. This is actually a complete mirror image of 2021 when Powell stated that inflation was just “transitory”. Having missed the inflation rise so badly the focus has gone singularly to inflation. That was understandable when “nothing was breaking” but that is no longer the case.
Headline CPI Y-o-Y has fallen every month since June 2022. While not yet at the Fed’s required level, which Powell said is 2% without flexibility, the trend is clear. JOLTS job openings had their biggest quarterly drop in history and the high to low move in 2023 is exceeded only by 2001, 2008 and 2020 (and we still have 9 months of prints to come). Initial weekly jobless claims are on the rise and the jobs quits rate is falling. Q1 GDP growth was just 1.1%.
More concerning was that Powell dismissed the debt limit with a single sentence and stated that the regional bank crisis was largely behind us given the situation had improved notably since the prior meeting.
This is still to be seen in our view. In the past two months we have had 3 of the 5 largest bank failures in U.S. history and the stress is still spreading among regional banks. We do not think this will be a repeat of the 2008 banking crisis but could be more akin to the Savings & Loans crisis of the late 80s, when 1600 small banks went under and which eventually led to a recession in 1991.
Therefore, we think the Fed will likely pause until at least September and see how the economy develops in the coming months.
As anticipated, the European Central Bank has given a similar message by raising the interest rate by 0.25%. President Christine Lagarde continued to characterize inflation as being too high for too long. Lagarde revealed that while some Governing Council members favored a 50bps rate hike, none suggested a pause on Thursday. And when probed about whether the ECB is near the end of the tightening cycle, Lagarde highlighted that it is a journey, not a destination. She ultimately stated that there is more ground to cover and characterized current interest rates as being restrictive, but not sufficiently restrictive. However, as inflationary pressures ease over the coming months, this will pave the way for the ECB to end its tightening cycle.
The Next Recession
We still believe that a global recession is not imminent. In other words, we do not expect a recession in 2023. Having said that, we will likely see a recession in 2024 as the impact of higher interest rates, combined with tighter credit conditions, will eventually slow the economy enough to create a recession. Especially, if the Fed keeps raising rates to fight inflation.
However, the depth of the next U.S. recession will be partly determined by its timing. If the recession begins this year, it is unlikely to be mild, because inflation will not have fallen enough to allow the Fed to cut rates aggressively. In contrast, if the recession starts in 2024 or later, when inflation is likely to be much lower, the Fed will be able to cushion the blow. In addition, a later recession start date would give banks more time to strengthen their balance sheets by rolling over low-yielding securities into higher-yielding ones.
Our base case remains a 2024 recession but the risks around that view have increased in light of the recent banking stress.
Investors often talk about the magnitude and timing of the next U.S. recession as though they are two separate things. In fact, the two issues are intricately related. Just as the passengers in a bus are more likely to be flung out of their seats if the driver slams on the brakes rather than pressing down on them gently, a recession that begins abruptly this year could end up being deeper than one that begins slowly next year. This is especially the case because right now, inflation is still well above the Fed’s target. Hence, for the foreseeable future, the FOMC will be reluctant to cut rates in response to sagging growth. However, if a recession were to start next year or later, when inflation is likely to be a lot lower, there will be more scope to ease monetary policy.
Fortunately, there are not many significant imbalances in the interest rate-sensitive sectors of the U.S. economy. If the Fed starts cutting rates next year, those sectors will respond positively, helping to ensure a mild recession.
Unfortunately, since both wage and price inflation tend to respond to changes in aggregate demand with a lag, there is a risk that the Fed will focus too much on these backward-looking indicators in setting monetary policy. Such a risk is not easy to dismiss. Having just brought rates to over 5%, the Fed will be inclined to keep them there for most of this year, since cutting rates so soon after raising them could convey the impression that the Fed does not know what it is doing.
Chinese stocks were the main underperformer in April despite decent earnings reports from the larger Chinese companies. The key reason was a weakening of key economic indicators that scared the market’s view that China’s rebound is already faltering. Incoming economic data confirm that China’s post-lockdown recovery is mixed. On the one hand, the end of the zero-Covid policy is boosting consumer spending – particularly on services. On the other hand, structural headwinds and the weak global economic environment remain a constraint on the manufacturing sector.
We think that China’s economy will continue to recover this year driven by consumer spending and a recovery in the property market. It will likely show a strong Q2 GDP growth given the low base last year. China does not need additional stimulus to achieve its GDP growth target this year, which has been confirmed at the April Politburo meeting. Existing, supportive macroeconomic policies will continue but there will not be new fiscal stimulus in Q2. The odds of further monetary loosening are also low for now. The fact that interest rates in China are likely to remain comparatively low versus the pace of economic growth, and that China’s property market is stabilizing, suggest that a major debt crisis in China’s household sector is unlikely in the near future.
We think Chinese equities are attractive after the recent sell-off. Valuations have come down and we think that there is a good chance that Chinese economic growth will surprise to the upside this year, which will support corporate earnings.
Quality Stocks Outperform
Many investors have been wondering why big tech stocks like Microsoft and Apple have done so well this year. One reason might be their quality. The quality factor has been the best performing equity factor this year. Most of these large growth companies have zero leverage and very high levels of profitability. This balance sheet profile has been an advantage in the current environment. While the main concern last year was rising interest rates, the key risk to the market this year is the high level of rates – and the defaults that they may cause. Companies with a strong financial position have outperformed, particularly following the banking turmoil in early March.
Returns for other factors have not been as attractive. Value stocks, which were a big winner last year, have had a disappointing 2023. While cheap, these stocks usually have more leverage and less profitability than the rest of the market – hurting them in an environment where credit risk becomes more important for investors. As a result, value stocks continue to suffer from higher interest rates and disappointing growth rates.
Quality stocks should continue to lead the pack in terms of performance. High interest rates will increasingly weigh on the economy, leading to a rise in credit defaults and benefiting stocks with strong balance sheets.
Bond yields have stabilized with the 10-year Treasury yield standing at 3.4%. This is quite a bit lower than the current cash rate of 5.25%. While cash rates have risen ~5% over the last 12 months, the 10-year Treasury is only up ~0.3%. We have a neutral view on fixed income as we do not think bond yields will fall much lower in the near future. At the same time, it is also unlikely that they will move much higher. So, the focus in fixed income portfolios is on generating current yield.
Stronger global growth and a narrowing of interest rate differentials between the U.S. and the rest of the world explain why the U.S. dollar has weakened since last October, especially versus the European currencies.
The U.S. dollar is a countercyclical currency, meaning that it tends to weaken when global growth is on the upswing. It is only when we see a meaningful economic slowdown that the U.S. dollar becomes attractive again.
Hedge Funds and Private Markets
Hedge funds as a group have underperformed equity markets since the end of the global financial crisis in 2009. Since the Fed started the current rate hiking cycle, the market backdrop has changed significantly compared to the last 13 years. Today we have much higher interest rates, higher inflation and more volatility in both bond and equity markets. This backdrop could be a positive environment for hedge funds as we saw a similar environment in the early 2000s and that was a good time to hold hedge funds as part of a diversified portfolio.
Under these circumstances hedge funds should be able to generate a return that is comparable to equity market markets return but potentially with less volatility. Hedge Funds will also have a lower correlation with equity markets and if they can deliver similar returns, they will improve the risk-return trade off in a portfolio.
In private markets, the environment is more positive for providers of credit than for investors in equity. In a world where credit is tight because of the regional banking crisis in the U.S., private lenders are at an advantage. Private equity managers now have a much higher hurdle to generate returns from company leverage. In short, private credit’s gain is private equity’s loss. As a result, we continue to favor private credit as part of a diversified portfolio.
We are focused on quality growth stocks in portfolio. We are still slightly underweighting the U.S. markets in favor of Europe and Asia, but have looked to decrease that underweight in some portfolios after European equities’ stellar start to the year. The overweight in Japan and China has not performed well in the past month but for both markets we still believe in the longer-term fundamentals, i.e. the weak Yen for Japan and stronger growth and earnings in China. Overall, we keep a focus on owning quality stocks in portfolio, which we think will continue to do well in the current environment.
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.
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The Consumer Price Index (CPI) is a measure of inflation compiled by the US Bureau of Labor Studies.
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