From Chris Iggo, Chief Investment Officer, Core Investments, AXA Investment Managers.
It feels like boom time. Markets are hitting all-time highs. The US economy continues to defy expectations, adding 303,000 non-farm jobs in March. There are green shoots of recovery elsewhere in the world. The idea that the Federal Reserve (Fed) might not cut interest rates at all this year is met with a collective shrug. Cash returns will remain attractive for some time. This year, equity returns are beating cash. High beta credit is also beating cash. Long-duration fixed income is down because of the shift in rate expectations. With yield curves remaining inverted, the longer-term bond yields are probably stuck in a range. The long duration trade will only perform strongly if growth and the inflation cycle weaken substantially. I have a feeling that’s not on the cards.
If the US economy avoids a hard landing, equities should continue to outperform bonds. We are not in a recession. The soft landing scenario is very much priced in and for the US at least, the data suggests it might be the softest of soft landings. The recession – if there is to be one – is delayed. Interest rates might have peaked but a long plateau could be ahead of us.
The inflation and interest rate outlooks are key. The surprise 0.4% monthly increase in the US Consumer Price Index (CPI) – both headline and core – makes it harder for the Fed to cut rates. We can argue endlessly about what is really happening with inflation given the computational issues with many components of the inflation index (owners’ equivalent rent, for example) and some strange price increases (motor vehicle insurance rates up 22% in the year to March 2024). But the cold hard truth is that progress towards the inflation target has stalled in the US and may even be reversing. Some members of the Fed may take comfort in looking at measures such as the CPI excluding food, shelter and energy (2.4% year-on-year in March) and argue that underlying domestic inflationary pressures are under control. But others won’t. For now, and this is the view the market is taking, a cut in June is off the table. Betting on any cuts this year has become a riskier undertaking.
Table Mountain redux
Months ago, we were talking about a ‘Table Mountain’ profile for US interest rates. That is how it is looking again. Rates have been on hold since last July. It looks like at least a year of rates at 5.25% – 5.50%. Just as a reminder, in the mid-2000s the Fed kept rates at the peak for 15 months. That profile creates one risk (notwithstanding where the neutral rate is), rates being held constant and forcing further adjustments in longer-term borrowing costs raises the profile of a hard landing at some point.
Also read: A Shift In Regime Marks The Start Of A New Era For Bond Investors
For bonds, credit and short duration
The market has punished long duration trades on many occasions in recent years and it is doing so again. It is unlikely to be a rewarding trade until there is more evidence of rate cuts or until there is a blow-off in the long end (US Treasuries above 5% yield) to improve the longer-term valuation argument. Finally, inflation-linked bonds, especially short duration bonds, might be something worth considering again as a hedge against inflation continuing to surprise to the upside. Five-year US breakeven inflation rates are just 2.55%.
A hike, anyone?
Rates on hold does not need to be a disaster once markets have re-priced the timing of rate cuts. What would be more of an issue is a Fed hike. No Fed officials have hinted at that publicly and it would be a surprise. But a mid-1990s profile could be a genuine scenario. If inflation moves back towards 4%, thus reducing real short-term rates again, then a rate hike is not unthinkable.
Sideways
Look at the headline year-on-year rate on a chart and it has been going sideways since the big drop below 4.0% last year. This suggests the Fed on hold, not the Fed tightening. Anyway, for now, it is prudent to reduce expectations of significantly lower inflation or rates for the rest of this year.
De-rating risk?
So, what takes multiples down and negates the positive impact of earnings growth on total returns for this year? The rates outlook is certainly one suspect, given what happened in 2022. There is hardly any gap between the implied earnings yield on the S&P 500 and the 10-year Treasury yield. If bond yields move higher, then equity P/E ratios might need to move lower. Signs of a recession would also do it as confidence in sustaining earnings growth would be undermined. But as I have argued, right now, there are few signs of a recession on the horizon. Political uncertainty could impact valuations. The US election is one source, but we won’t really know until Q3 how things are panning out.
Global political risks are perhaps more concerning as a threat to investor sentiment that would require a higher risk premium in equity markets. It is hard to assess what the true situation is like in the Russia-Ukraine conflict, as there continues to be reports of a potential Russian surge while other reports highlight infrastructure issues and unrest in Russian regions which could potentially undermine the regime. In the Middle East, the threat of an escalation of Israel’s conflict beyond Gaza to Iran looms. Geopolitical analysts are going to turn up the volume as they debate issues ahead of the US election. All of this has the potential to be reflected in greater investor uncertainty and thus higher volatility and less certain returns. The recent rise in commodity prices could be a sign of concerns about geopolitical risks to the supply of key commodities, or just a sign the global economy is stronger than we thought.
Boom or pow?
I started with a suggestion that the global economy is doing well. Growth momentum is improving, and disinflation is still the trend, although disrupted by higher energy and other commodity prices and post-COVID-19 price trends dictated by structural shifts in spending and market structures. It’s fair to say that nominal growth is going to be higher than in the pre-pandemic period, which means higher interest rates than back then. In addition, companies have proved to be resilient and can grow, adapting to changed demand and supply conditions and the opportunities provided by new technology. Investors have the opportunity for more balance in their portfolios, as I have been arguing for a while. Bonds for income (manage the interest rate sensitivity), US equities for growth, and global markets for diversification offered by signs of more balanced global growth (even if that is a derivative of a strong US economy).
