Investment Strategy Insights: View From the Top (of the Monetary Cycle)

Stance: The labor market continues to show signs of weakening. While jobless claims fell to 201,000 in September from 230,000 in August, suggesting that companies likely aren’t actively laying off workers, job openings fell to 8.8 million in July, the lowest level in more than two years, indicating that companies are pulling back from seeking new workers. While non-farm jobs remain elevated, revisions have consistently been negative, bringing the robust headline numbers down to a more neutral level. Finally, consumer confidence has fallen to 106.1 from 117, indicating that consumers are starting to have concerns about their employment situation. In addition to the normalization of the labor market, the impact of auto strikes, student loan payment forbearance ending, and a potential government shutdown must be considered.

Inflation in the US remains stubborn, with the headline figure rising to 3.7% despite core falling to 4.3%, as base effects and energy prices drive the differences. The question regarding inflation is no longer about the direction, but about the speed at which it will fall and the ultimate level at which it will stabilize.

The European Central Bank (ECB) completed what it projects to be its final rate hike, emphasizing that policy will remain as restrictive as needed for as long as required. The focus remains on wage growth and the effect a more rigid labor market will have on the duration of above-normal wage growth. In the UK, wage growth continued to climb to 8.5%, while the Bank of England decided on a hawkish pause in a five-four vote. Despite the higher wage growth, the UK did see a slowdown in core CPI to 6.2% from 6.9%.

Risks: 1) Inflation falling faster than expected or the Federal Reserve looking through services inflation and pivoting earlier; 2) Systemic issues in either Europe or the US; 3) More resilient economic fundamentals across Europe and the US.

The market has finally reached decent value, leading us to change our stance to neutral. Fiscal spending remains a problem, with the nonpartisan Congressional Budget Office forecasting $2 trillion in annual spending over the next 10 years. After the CBO report came out, researchers tried to “game theory” the mix of bonds the US Treasury would have to issue to reach that $2 trillion per year estimate. Wall Street now warns of fiscal difficulty as the Treasury moves from more T-bill issuance today to more duration issuance in 2024. The way to avoid or lessen the blow of increased duration issuance would be to increase taxes, but the election year makes that all but impossible. The Federal Reserve shows little inclination to help, and meetings and minutes have been uniformly hawkish even through the banking crisis this past March. Currently, there is good value in the US 10-year at 4.50 or higher. We anticipate a bit more steepening in the 30-year long bond; the 20-year is a better proxy for that risk on the curve. The short end of the curve should stabilize by year’s end and is a decent place to put money during an uncertain fourth quarter. We expect cracks to begin to show in the credit and equity markets as “higher rates for longer” sink in.

Treasury yields have hit new cycle highs following the Fed meeting that revealed a revised forecast. Anticipated now is a stronger economic outlook (lower unemployment and a higher GDP forecast) and reduced rate cuts despite expectations for declining inflation. Despite its history of poor forecasting, the Fed nonetheless expects a soft landing. Outside the US, the picture has shifted toward a more negative outlook. Valuations have not moved much, but with a higher probability for a more benign base case outlook, we have incrementally improved our score to reflect an outcome where higher-yielding credit assets should outperform over the next 12 months. Under a decelerating economy and a BB-BBB differential of about +100, we would be expected to favor investment grade (IG) credit. But the roughly 300-basis-point (bp) differential in overall asset class yields along with greater comfort with single-B credits results in expectations that high yield (HY) will outperform. Similarly, single-B loans are outyielding comparably rated HY by 200 bps, resulting in favoring floating-rate credit, although the convexity has been greatly reduced. Geographically, with European-US spread differentials narrowing despite diverging outlooks, we are shifting toward underweighting Europe versus the US. While EM valuations look compelling, after one adjusts for the valuations of stressed elements they are more fair than cheap.

Divergent US and Europe economic growth paths have become more evident, bolstering demand for the US dollar. The extent to which that may further boost the dollar will rest on Fed and ECB rate expectations going into 2024. While we have turned slightly more bullish on the dollar than we were earlier in the year, trade data and long-term valuations suggest it is already moving into overvalued territory, which should help limit gains. Fiscal support and surprisingly resilient consumer spending are the primary drivers of the upside surprises in US growth, while Europe, and particularly Germany, has been hit harder than anticipated by China’s downturn and Germany’s failed energy transition policy. Considering the dispersion in growth outlooks between the US and the eurozone, central bank reaction functions now seem more aligned, with some suggestions that the ECB could even start reversing its rate-hiking cycle sooner than the Fed in 2024. Higher inflation expectations in Europe, however, would argue against this. The US dollar is clearly benefiting from a regime of loose fiscal policy/contractionary monetary policy. While tailwinds from the fiscal stimulus may wane in 2024, it is hard to see the same factors turning into headwinds without policy intervention. In parallel, the return of US exceptionalism may drive the US dollar stronger into year-end, although positioning argues against any oversized moves. Financial markets are running out of patience with the theme of “long and variable lags,” clearly buying into “soft landing” and “high for longer.” However, we would caution that fourth-quarter activity is expected to slow in the US, and the rising interest burden and medium-term financial stability risk remain black spots on public debt.

The global macro outlook is increasingly bifurcated as the US economy, having rebounded in the second quarter, shows signs of waning in the fourth, while China’s growth outlook has already been revised materially lower and shows no sign of bouncing given the lack of broad-based policy stimulus. Our theme of widening growth differentials between emerging markets (EM) and developed markets (DM) remains intact for 2023, but sideways growth in EM means the dispersion is being driven predominantly by the deteriorating outlook for DM growth. Disparity in inflation trends is growing between top-down and bottom-up signals. Significant deflationary forces stemming from China add to the positive disinflation trend in Latin America, yet evidence of cost pressures building among companies has detracted from the positive tone, making the job of central banks in Latin America more challenging. Downside risks to the US economy have faded, with the massive and unexpected fiscal stimulus blurring the outlook for the second half of our 12-month forecast horizon. Monetary policy tightening has peaked, but uncertainty clearly remains over the chances of any rate cuts in the second half of 2024. Leverage is creeping marginally higher in EM corporate debt (0.9 to 1.0 in IG and 2.0 to 2.1 in HY, respectively), and there are some signs of poor cost control albeit only on a company-specific basis rather than industrywide. Latin America is the highest-leveraged region. The downturn itself is coming from a very high base, and so far has not tipped us into a more pessimistic cycle. Our analysts are predominantly screening companies as neutral after second-quarter earnings and, if anything, surprises have been mildly to the upside. We kept our “Classical” scenario unchanged at 55%, while markets arguably are pricing in a soft landing at this stage.

The surge in US Treasury yields reflects the confluence of several factors: optimism on growth, Fed minutes suggesting that quantitative tightening (QT) will persist even after nominal rate cuts begin, and an end in sight for yield curve control in Japan, as well as the outlook for Treasury issuance catching up to the implications of a late-cycle fiscal thrust. While the fiscal thrust has pushed slowdown/recession risks out into 2024, its “dark side” is tighter financial conditions that pressure valuations. Into this backdrop, the Fed signaled that QT will last longer, well beyond the anticipated mid-2024 cuts to nominal policy rates. The Fed wishes to get its balance sheet back down to a level of “ample reserves,” which appears to mean 8% of GDP – a metric that is unlikely to be achieved until 2025. All told, liquidity deterioration will accelerate in the quarters ahead. While inflation has begun to come down at an increasing pace, in our view this largely owes to the unwinding of transitory forces that drove up one-third of prices very rapidly, which are now coming down very rapidly. Only time will tell; the Fed remains in no hurry to bring rates, either real or nominal, down in 2024. Meanwhile, monetary policy works on the weakest links, often small companies. Indeed, indicators have shown an uptick in bankruptcies among smaller firms. And the trouble is that this is where most of the jobs are, feeding top lines for the larger firms that market analysts follow. The upshot is that monetary policy is now restrictive and will have a cumulative effect on growth over time, particularly once the acceleration of the fiscal thrust slows. Despite the factors above, production of consumer goods has been running well below retail takeaway since retailers sounded the alarm on excess inventory in the channel last holiday season. A temporary spike in purchasing managers’ indices to address this undershoot would mostly benefit Asian exporters and may present a cross-current to transitory disinflation. This would pressure yields further, as would China’s presumed imminent rate cuts on existing mortgages, financed by cuts in deposit rates, to nurture more consumption.

Sentiment in technology cooled after the second-quarter earnings season due to a lack of visibility on a second-half recovery. In software, IT spending remains weak, and companies pushed out AI-driven growth into 2024. Semiconductors and hardware continue to deal with weak spending on PCs, smartphones, and traditional datacenters, although the worst of the inventory issues appear to be behind us. In addition, there have been increased concerns about harsher US-China trade restrictions due to the recent developments in the Chinese semiconductor industry.

In China’s automation sector we are seeing margin-defending cost-optimization measures following price cuts in the year’s first half. There are signs that PC shipments could recover in the fourth quarter or first-quarter 2024, although the smartphone supply chain is still sending mixed messages. Property fundamentals remain weak, but there was some improvement in August as macro data showed stabilizing or expanding PMI, CPI, and other metrics. Meanwhile, Chinese equities are at attractive valuations. In India, consumer staples companies have begun passing on lower raw materials prices to customers through price cuts. Auto demand remains strong, and the country’s largest car company announced plans to double capacity over the next four to five years. Software companies have announced a few large deal wins, indicating that the worst of the demand slump may be over. In Brazil, banks have remained cautious as new loans fell and credit growth decelerated despite strong macro readings, which most likely contributed to the negative performance of the financial sector. Latin America’s recent performance again seems driven more by US rate concerns than stock-specific news. In Emerging Europe, investors are unnerved by Hungary’s proposed new bank tax and Poland’s populist rhetoric before parliamentary elections. South Africa continues to suffer from multiple problems and lack of reform. The emerging consensus out of the US and the EU about the war in Ukraine seem to be that it will last for years to come. It seems we are once again in a period when top-down and geopolitical currents overtake company fundamentals and perhaps drive them to some extent. We continue to focus on companies with strong and improving business models, quality management, sound financial structure and proper adherence to ESG values.

Driven by a steeper curve (+7 bps), our US Conviction Score improved to 3.97. With global credit forecasts negative, our model slightly favors EM over DM. In DM industries the model favors industrials, technology, finance companies, energy, and brokerage and insurance. It dislikes communications, electric companies, utilities, and natural gas. Among EM industries, the model likes transportation and oil and gas; it dislikes real estate, utilities, and diversified. The global rates model forecasts lower yields globally, a flatter curve in Japan and Norway, and no change in Australia and Germany, but a steeper curve in the US, Canada, and New Zealand. Most euro curve forecasts edged up to slightly steeper from no change. The rates view expressed in our G10 Model portfolio is overweight global duration with overweights for North America, France, New Zealand, Japan, and Italy, and underweights for other parts of Europe and Australia. Along the curve, it is overweight in six-month and 20-year durations and underweight in five-year, 10-year, and 30-year durations.