Investment Strategy Insights: Are Profit Prospects Dimming?

Stance: We kept our Global Macro score unchanged with its moderately bearish tilt. While the tough talk coming from Jackson Hole slapped the equity market and could indicate a greater likelihood of tightening excess, it’s also possible that steadily declining US inflation could do the Fed’s job and lead to much lower rate expectations for next year. That would remove Fed policy error as a potential recession source. Slowing inflation also could translate into real income growth if tight labor supply keeps wage growth elevated. That should allow consumption to rebound and remove a second recession source. Our European CS remains at 4 given the continued upsurge in inflation and the continued deterioration in its economy’s vital signs. The upcoming Italian elections also mean elevated political risk. My China CS remains at 2.75; the weaker near-term data flow is already stepping up the policy response, which should deliver better growth in 12 months’ time. Finally, emerging markets (EM) PMIs have proven quite resilient despite substantial policy tightening, but protracted inflation and the strong US dollar are keeping my EM CS at 3.25.

Outlook: Our base case remains “Slowdown, no Recession.” Absent a gas shock in Europe, we expect global GDP growth to remain weak this year, but with prospects improving during 2023 if inflation slows more noticeably everywhere, which would allow real wage growth to rebound and could prompt rate cuts starting in some EM economies.

Risks: 1) Escalating geopolitical crises, 2) Central bank policy errors in the form of excessive tightening, and 3) Normalization in labor demand, marking an end to the tightly-packed economy

The Federal Reserve’s confusing rhetoric – trying to show resolve in fighting inflation while not riling the market – is adding to volatility in an already illiquid market and weakening the government’s creaky credibility. As a result, our base case continues: The Fed puts on a brave face, but ultimately pivots to stop the recession. The market acts as if that has already happened. Since Fed Chair Jerome Powell’s comment on 27 July that the neutral rate is 2.25% to 2.5%, which the market interpreted as a pivot that placed the Fed “put” back on the table, Fed funds futures have dropped 25 basis points (bps), Eurodollar futures have declined, the Nasdaq Index shot up 14% in 15 days, and the five- and 10-year breakevens in TIPS have improved, signaling higher inflation. The burden of proof now falls squarely on the Fed to demonstrate its inflation-fighting determination. More waffling will be translated into inaction. Currently, the 20-year part of the curve looks most attractive, followed by the seven-year. The 10- and 30-years appear rich.

August’s continuing positive market tone has extended to the point where valuations do not reflect the myriad of downside risks. Therefore, it is prudent to use the current market rally, particularly in assets below investment grade (IG), to reduce portfolio risk and become more defensive once again. With the very strong rally in high yield (HY) that recently has been testing +400 levels, we have reversed our prior preference for HY over IG and currently believe the differential is too tight given a slowing global macro environment. Our defensive bias now favors IG credit, and we continue to prefer US over the rest of the world. While we would agree that the Fed will be slowing its pace of rate hikes, the market’s pricing of easing in 2023 is misguided. We believe there will be a much higher hurdle for any easing, creating conditions that call for risk aversion.

The eurozone’s return to positive interest rates, a lower US Consumer Price Index (CPI) print, and stronger US employment numbers have prompted some unwinding of US dollar longs in illiquid foreign exchange (FX) markets. Critical for US dollar bulls, the euro has failed to break above the key technical level of 1.035, keeping our long US dollar as “best house on a bad street” thesis intact. We believe that as winter approaches, Europe’s higher energy costs will lead to lower growth, energy rationing, and reduced employment, all tying the hands of a hawkish European Central Bank and pushing the euro to 0.9300. The eurozone’s sticky inflation path will keep European real yields lower than those of the US, which will see a quicker fall in its inflation. The bad news for the British pound is mounting too. The Bank of England’s (BOE) August meeting delivered the frightful combination of a 50-bp hike and a five-quarter recession forecast. This reaffirms that the BOE has limited room to hike, compounding Britain’s persistent and worsening current account, which will need financing from a further weakening pound.

In Japan, the waning impact of the terms-of-trade shock removes one of the factors that drove the Japanese yen to its 24-year low. We maintain our 12-month forecast of 147 based on the dovishness of the Bank of Japan. However, we acknowledge that the Japanese yen is undervalued according to most long-term valuation models, making the euro the likely new funder for investors willing to remain long the US dollar.

With markets focused on how the US Federal Reserve will proceed with its tightening, we’re keeping our global macro scenario weights unchanged, firmly in the global recession camp. The economic outlook has hardly changed since June despite the Powell pivot and market relief rally. At that time, we reduced the probability of our “Cruise Along” scenario to 30%, increasing our “Bear-on-a-Leash” outlook to 40% and our “Armageddon” probability to 30%. We improved our score on US dollar emerging market debt due to a decline in rate volatility and better technical market conditions. While coming off a high base, which is why we are more neutral, the fundamental picture for EM remains reasonable with pockets of positive outlooks. We maintain a defensive approach, favoring higher-quality names with selective HY exposure.

With the reopening behind us and no longer buffering a slowdown, we maintain our cautious score. Most concerning is wage growth data. Although average hourly earnings are slowing, more accurate measures of wage growth, such as the Atlanta Fed’s Wage Growth Tracker and the Employment Cost Index, continue to accelerate. We now fear that tighter financial conditions are still required. From a bottom-up perspective, the overall message is shaping up as slow deterioration in current-quarter earnings and downgrades of 2023 expectations. For now, the erosion is slow and the market has taken heart from better-than-feared results. Overall, we see a looming GDP growth scare with an earnings recession. While the Fed is likely to stop hiking at 3.25%, quantitative tightening will be notched up in September. The tightening is likely to be long-lasting with sticky inflation unless we get into a deep recession.

The market is in a constant debate about the durability of inflation and the monetary response. In the past month we’ve seen increasing signs that non-labor inflationary pressures are easing, which has made the market more hopeful that a soft landing can be achieved. Second-quarter earnings reports so far are showing that companies have generally been able to navigate the complex environment well. It appears that pricing power remains robust across most end markets, and supply chain pressures are easing on the margin. Guidance has remained conservative given ongoing uncertainties. The market weakness presented us with opportunities to upgrade the portfolio and invest in companies that are typically richly valued. As always, portfolio style balance remains a key component of our risk management.

In China, July industrial output rose 3.5% year over year, which lagged forecasts but constituted the third consecutive month of acceleration. Zero-Covid policy remains a headwind and is causing an uneven recovery. In India, most consumer companies increased prices to offset cost pressures. Balance sheets of companies are robust, with low debt levels, while banks have cleaned up bad loans such that their balance sheets now sport the healthiest net nonperforming asset (NPA) ratios in a long time. Strong earnings at portfolio companies have improved the outlook for Latin America, where some of investors’ biggest macro and political fears have not come to pass. Uncertainty prevails in Central and Eastern Europe, but that is reflected in asset prices. It is too early to predict the path of the conflict in Ukraine, which has lost some of its recent intensity, but it’s noteworthy that more cargo ships are leaving port due to the grain export deal. We remain of the view that long-term opportunities in global EM are some of the best that we have seen in years.

Our US Market Cycle Indicator (MCI) deteriorated to the risk-off zone at 4.03, with a flatter curve (at -28 bps) outweighing tighter BBB credit spread (at -10 bps). The Global Corporate Model remains positive on EM and negative on developed markets (DM), where it favors energy, natural gas, electric, and utilities, and dislikes financials, brokerage, and basic industry. In EM countries, the model favors Israel, India, Argentina, Indonesia, and South Africa and dislikes Hungary, Colombia, Turkey, Chile, and Thailand. Among EM industries, the model likes oil and gas, and pulp and paper. It dislikes real estate, metals, and transportation. The Global Rates Model continues to forecast a lower yield and a flatter curve. In the G10 Model Portfolio, the rates view expressed is overweight global duration. It is also overweight North America, underweight Europe (where it is overweight peripheral countries and underweight core countries), slightly overweight Australia/ New Zealand, and slightly overweight Japan.