If everyone is surprised is it really a surprise?
Consensus has taken a beating but is still standing.
The story is somewhat different in the emerging markets. There, fixed income assets ended the spring quarter on a very strong note, generating substantial excess returns related to U.S. Treasuries as EM spreads tightened by 70 basis points to finish June at 682 basis points. While the broad market performed well, much of the tightening was attributable to a strong rebound in Argentinian assets. Our fixed-income international team took profits on this trade late last month, moving our model portfolios to neutral, but still see the potential for more upside before year-end once EM markets work through the risks associated with the risk-off move we are expecting in developed markets.
The first six months was a consensus killer—practically every investment narrative came under attack. Aggressive tightening by the Fed and other global central banks was supposed to slow consumers, thereby easing inflation as demand wilted and unemployment rose. An earnings recession was certain to follow, stoking volatility, depressing equity valuations, widening credit spreads (the yield gap with comparable maturity Treasuries) and further weakening the dollar. Well, it’s halftime and events obviously didn’t stick to the script. To the contrary, runaway equity valuations simply ran higher, rich credit spreads tightened further, and cheap volatility levels only got cheaper. In fact, the Nasdaq Composite enjoyed its best first six months ever!
When things aren’t going so well, good teams usually make halftime adjustments. But to act differently now would be to accept that 2023 will emerge as the only economic cycle where past economic patterns did not apply. Not sure that’s a bet we would want to make. True, the global pandemic generated a host of social and economic distortions that simply were not present in past cycles, with trillions upon trillions of fiscal and monetary stimulus pumped into economies—$9+ trillion in the U.S. alone. Unprecedented. Perhaps that old Wall Street maxim, “Past performance is not a guarantee of future results,” is appropriate for these times. But looking at the state of things suggests at some point, there will be pain. Stimulus doesn’t last forever and it’s evaporating quickly.
Indeed, with inflation still “sticky” all over—in services and wages in the U.S.; in Europe where May’s year-over-year core CPI rose to 5.4%; and particularly in the U.K., where May prices were outright HOT as core inflation reaccelerated to 7.1% on broad-based pricing pressures—central banks are far from backing down. Just two months ago, the Bank of England was believed to be the first among the developed major central banks to bring an end to its hiking regime. Now, on top of June’s half-point hike to 5%, there’s talk of another half-point move and a terminal rate of 6% or higher. Even with eurozone PMI in contraction, the ECB says it’s not done—we’ll find out more with this week’s reading on euro CPI and next week’s policy meeting. As for the Fed, despite June’s CPI beat to the downside, futures are still pricing a near-certain probability of a quarter-point hike next week.
There may be “long and variable lags” before all this tightening takes full effect, but it should eventually take effect. Developed economies already are slowing (the latest Zew and Sentix surveys were stinkers) and there’s no reason to think they will make a U-turn now, not just over a year into a rate-hike cycle. We see the potential for recession by year-end and into 2024, generating a risk-off market. If history is any guide (and I realize I just cautioned that maybe it’s not), such moves tend to be quick and violent once markets start pricing in what’s to come. (Witness the sharp drops in the 10-year Treasury yield and the dollar after last Wednesday’s weaker-than-expected CPI report.) That’s why we believe patient bond investors who stick with defensive positions on credit and remain long on rates (above benchmark on duration and overweight the shorter end of the yield curve) ultimately could be rewarded.