Concerns grow for the global economy, inflation is not beaten, says Morgan Stanley Investment Management
As the challenge of bringing down inflation remains ongoing, the Fixed Income team at Morgan Stanley Investment Management note that there is no doubt the global economy is slowing, raising more challenges to central banks to juggle financial market stability with a forceful commitment to bringing down inflation.
And, ever in the minds of bond investors is the question about how banking issues will affect central bank’s ability to lower inflation.
The Fixed Income team at Morgan Stanley adds: “Given the uncertainty, we recommend remaining flexible. Markets tend to over and under react We hope to take advantage of this as the year progresses.
“Despite ongoing issues in banking and weaker than expected data (generally speaking), financial asset prices outside of banking were surprisingly calm. It is almost incredible to believe that in a month with the second largest bank failure in history, global asset prices were the least volatile since the beginning of the pandemic by the metric of percentage of assets moving less than 3% in either direction and by VIX, a measure of equity market volatility, returning to levels last seen in late 2021.
“The Fed is now in wait and see mode and has made no indications it is ready to even think about cutting rates, while the market has other ideas. Financial market futures contracts are now anticipating about 100 bps in rate cuts in the second half of 2023. It should not be a surprise that given 500 bps of rate hikes in a little over a year, various leveraged business models, such as banks, might come under pressure, even if monetary policy tightening was well executed. But it could get worse and there are likely to be more casualties of the inflation fight. That does not mean there will be a crisis, but rather economic weakness and hopefully a faster drop in inflation, which would allow the Fed to reverse some of its tightening in 2024.
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“A key factor in understanding what comes next in the U.S. will be measuring how tight monetary/financial conditions have become. By the standard of short rates, they are at a minimum moderately tight or significantly tight if you use a long run inflation rate of 2% to calculate the real Fed funds rate. Bank credit conditions are clearly on a tightening trajectory, although by how much remains to be seen. However, if we look at government bond yields, credit spreads, the S&P 500 and energy prices, things are looking up, meaning that the movement in these variables does not suggest financial conditions are tightening.
“The inability of government bond yields to fall in April post the March rally suggests that further movements in yields will necessitate, in our view, one of two events transpiring:
- A crisis unfolds, the Fed cuts rates and yields fall; or
- A crisis is avoided, inflation may or may not fall significantly, but bond yields rise.
“Scenario two is bearish for risk-free bonds, but supportive of stable to tighter spreads on corporate bonds and securitized assets, and we would not expect a significant back-up in U.S. Treasury yields beyond their recent ranges. For example, 10-year U.S. Treasury yields have been in a broad 3.3% – 3.7% range for a while now. This is unlikely to break, barring scenario one coming to pass. German government bond yields are also probing the bottom of recent ranges in a market where inflation is in worse shape than in the U.S. Keep in mind that in scenario one, the market already has 100 bps of rate cuts this year and another 100 bps next year. Expectations would likely have to exceed this number to get bond yields meaningfully lower.”
So where does this leave us?
“We are concerned about the global economy. While growth looked like it was accelerating through the first quarter, it decelerated towards the end, suggesting that in conjunction with banking sector woes and what the ECB characterized as “forceful” transmission of higher rates into the economy, second quarter growth may be weak. Moreover, there is no doubt in our minds that employment growth is slowing in the U.S. (less so outside the U.S.) and headline inflation is falling. This augurs well for no further Fed rate hikes.
“But inflation is not beaten, neither in the U.S. nor in most other countries. Even though central banks are at or nearly at peak terminal rates, we believe they will be reluctant to cut rates simply because unemployment rates rise. The Fed and most other central banks need to see higher unemployment rates simply to stop hiking. But, to further complicate matters, central banks must also ensure financial market stability, which may constrain their ability to maintain moderately tight monetary conditions for a long time, pushing out success on the inflation front. Indeed, one risk investors must remain vigilant about is the possibility that worries about financial contagion and systemic financial sector risks are pushing out into the future the attainment of long-run inflation goals. If true, by design or by accident, this would steepen yield curves and add an inflation risk premium to longer maturity bonds.
“In terms of strategy, we continue to run longer duration than pre-SVB and buy additional duration on any setbacks in yields. We look for ways to intelligently upgrade credit quality, minimizing give-ups in expected returns. We think credit markets look modestly undervalued but, in the investment grade space, come predominantly from bonds issued by financial institutions. Spreads are above average but not materially so, making credit a carry game with limited opportunities for spread compression.
“Given that we expect an economic slowdown but no big recession this year, shorter-dated high yield bonds look fair and, if chosen carefully, can potentially generate an attractive return.
“Securitized credit continues to look more attractive than any other sector. We think the credit risk of residential and selective commercial mortgage-backed securities (MBS) like multi-family housing is attractive given the strong starting point for household and corporate balance sheets, and strong household income growth.
“Our favourite category of securitized credit remains non-agency residential mortgages, despite expectations that U.S. home prices will likely fall in 2023. Recent events continue to be negative for the U.S. dollar U.S. growth is likely to weaken more than in many other countries, supporting the idea of monetary policy tightening further outside the U.S.
“If the Fed holds policy rates unchanged to combat inflation in the face of weaker data and/or banking sector stresses, it is likely to be negative for the dollar. If the Fed cuts rates while inflation is still too high in response to economic weakness or financial stability concerns, it is likely to be negative for the U.S. dollar.
“We continue to like being underweight the dollar versus a basket of developed and emerging market currencies. We also continue to like emerging market local government bonds versus hard currency debt.”
