Investment Strategy Insights: Resolving a Kaleidoscope of Economic Drivers

Stance: A drop in the ISM Services purchasing managers’ index (PMI) to 49.6 has put the market on edge about the possibility of a recession, as its concerns about inflation fade with the continuing decline in the US Consumer Price Index (CPI). The Federal Reserve, meanwhile, continues it hawkish tone, talking about slowing the pace of hikes or pausing, but not pivoting toward cuts, especially as labor markets remain firm and consumers continue to be optimistic. The University of Michigan Consumer Sentiment1 has risen from 2022 lows of 50 to a current level of 64.6, and the Conference Board survey remains above 100.2 Europe remains fragile, although unusually warm weather may have averted a winter recession. Still, worries remain about the potential impact of an extremely hawkish European Central Bank (ECB) and gas supplies for next winter. China remains the bright spot, with the focus on the reopening later in the first half of the year.

Outlook: If the market sees inflation continuing to fall, growth will become an even bigger focus. Recent data have been positive, and the market has reacted accordingly. But monetary policy operates with a lag, creating challenges for the second half.

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

The last two weeks of 2022 were hardly a lull, as the Bank of Japan (BOJ) expanded its target on the Japanese government’s 10-year bond to 50 basis points (bps).3 That prompted us to become bearish after our nanosecond-long sojourn into neutral territory. The trifecta of a hawkish Fed, a hawkish ECB, and a BOJ worried about the dollar/yen relationship caused the US 10-year bond to rise as high as 3.90% before ending the year at 3.87% — a sizable jump from the 1.5% level at the start of 2022. As a result, the US Treasury index was down 12.46% for the year. The European market fared even worse, with the Euro Treasury index down 18.48% in euro terms.

January saw a strong rally in credit spreads due to supportive technical factors and improved expectations for fundamentals in the US and Europe. But the market may be overdoing it, pricing in a Goldilocks scenario of no recession, slower inflation, and Fed rate cuts toward the end of the year. While improving fundamentals have reduced the probability of a hard recession, we do not see a Fed rate-cut later in the year. As a result we believe valuations are getting ahead of what expected fundamentals justify. In particular, with corporate earnings becoming more challenging over the next 12 months as margins come under pressure, we maintain our defensive score and positioning.

High yield (HY) spreads were starting to approach +400 levels before widening to the +425 area, whereas investment grade (IG) spreads have been more stable and have tightened to +115 levels. With BB-BBB differentials in a tight 110-120 range, we continue to prefer higher quality IG over HY, although HY remains an attractive alternative to equities.

In Europe, the warm winter has substantially reduced the likelihood of a hard recession, but ongoing ECB tightening will start having a larger impact on the economy later this year. Despite the strong rally in European credit, we believe there is still value within the IG component but would hold off for now on adding to below-IG credits. With China reopening, the Asian credit outlook is continuing to improve, providing support across emerging markets (EM).

The US dollar has been on the defensive since December, initially on market optimism over the timing of a Fed pivot and more recently by improving cyclical data from the eurozone and the quicker-than-expected reversal of China’s zero-Covid policy. We continue to hold onto the view that the rate differential will remain more in the US dollar’s favor than what is currently being priced by the market. This is the crux of our bullish US dollar call. Thus, we expect that the Fed will hike to 5% and remain on pause for longer than the market expects, while the ECB will reach only 3%. We believe growth rate differentials won’t be as bullish for the US dollar as rates. Since the US dollar tends to have a negative relationship to global growth, the currency’s safety is less in demand when the rest of the world is booming. A faster reopening of China and Europe finding itself with unexpectedly low gas prices and high gas inventories have buoyed the world’s growth forecasts and slowed US dollar demand. We expect that the Bank of Japan’s market-surprising move to maintain the yield curve will only delay ending its yield-curve control efforts. February 10, when the announcement of a new BOJ governor is expected, and early April, when current governor Haruhiko Kuroda’s term ends, are key times to look for possible policy changes.

EM fundamentals remain strong, with growth set to modestly accelerate in the face of a US growth rate expected to grind to a halt this year. China’s sooner-than-expected reopening and the rosier outlook for Europe, an important EM trading partner, support our EM growth outlook and our optimism over EM fixed income. On the technical side, the large redemptions scheduled for the first quarter will eclipse January’s heavy issuance. Yet with a strong rally already behind us and the team’s view that the US will not cut rates this year, relative return expectations are muted. Sovereign high-yield returns are 7.7% and corporate IG is at a risk-adjusted 5.5%, making the latter look more attractive. We see 2023 as the year of US Treasury carry, and we will focus on that security’s volatility to provide entry points and opportunities to extend duration. We continue to look toward credits that are shielded from tight global financial conditions, while at the same time rotating our focus toward those that will benefit from China’s reopening. By category, our return expectations based on our classic recession scenario are: EM hard currency sovereign broad, 6.2%, with IG at 4.7% and HY at 7.7%; EM corporates broad, 6.9% (IG 5.3%, HY 8.8%); EM local broad, 7.0% (FX 0.1%, rates 6.9%). At 60%, a classical recession remains our base case, with a 20% case for a pivot, 10% for stagflation, and 10% for a soft landing.

While China’s reopening will undoubtedly be bumpy, it should ultimately help offset the depth of recession in the rest of the world. Meanwhile, risk assets remain challenged by an impending decline in inflation-boosted corporate profits amid falling pricing power and sticky labor costs, along with an ongoing squeeze in liquidity via quantitative tightening (QT) that will continue long after rate hikes end. This leaves us cautious.

We see China as a preferable investment path in 2023 given the likelihood of sequential rolling recessions in Europe and the US driven by hawkish central banks. What’s unknown is the degree to which China’s reopening and regulatory rollbacks will provide meaningful stimulus to other emerging countries, as its prior stimulus efforts have tended to do, yet this time the global cycle is more desynchronized.

Elsewhere, forward-looking, expectation-driven soft data have meaningfully weakened, while the hard data that central banks and investors tend to lean on has not. This growing gap is just one more fear factor encouraging central banks to play it safe in their inflation-fighting efforts by leaning against growth. Drops in cash flows and liquidity, and thus the capitalization of those cash flows, can spur consequential market downdrafts. If rates rise above today’s levels and persist for an extended time alongside QT, liquidity could tighten more than at any time over the past 40 years of disinflation. This is occurring against a backdrop of margins that are declining to more normal levels after profits spiked in recent years due to massive fiscal stimulus that pushed up demand amid supply bottlenecks that supercharged pricing power. All those forces are now reversing.

As we head into earnings season, companies are for the most part still seeing good demand trends although there are signs of some deceleration and concerns about the potential for a hard landing. We see some reasons for optimism later in the year due to easing inflationary pressures, the moderating pace of rate hikes, and improving supply chain conditions, especially with the reopening of China.

Over the last few months, we have seen end demand continue to decelerate across most verticals, but we also are seeing greater investor appetite to push into growth names based on a potential recovery in the second half of 2023 or in 2024. This trend is most apparent in sectors hit earliest, such as tech and communications. In healthcare, companies have been generally anticipating more stabilization in 2023 as compared with the deceleration of 2022. Regardless, the market continues to be volatile due to different perceptions of Fed monetary policy. This presents us with opportunities to upgrade the portfolio and invest in advantaged companies at valuations below typically high levels. As always, portfolio style balance remains a key component of our risk management.

We maintain our neutral score on rising valuations that are being offset by improving fundamentals. The MSCI Emerging Markets Index (MXEF) is up more than 22% from its recent bottom in October, for example, while earnings forecasts that previously were coming down in several sectors and geographies, most notably Chinese internet platforms, look brighter. Investors are trying to estimate the economic impact of China’s reopening and the best way to position. Overall, interest is returning to previously unloved parts of Asian markets. Latin American commodity, consumer, and financial sector companies will benefit from China’s reopening, while Mexico will see a positive impact from near-shoring and remittances. In EMEA, Central and Eastern European companies still contend with the war’s impact, while companies in the Middle East and Africa generally are neutral or beneficiaries. We continue to engage with portfolio companies with the goal of improving their ESG attributes and enhancing their long-term prospects.

Our US Conviction Score improved to 4.08, mainly driven by a steeper curve that is 17 bps less inverted. Our global credit forecasts remain positive on EM and negative on developed markets (DM). In DM industries our model favors insurance, capital goods, and banking and dislikes financials, communications, REITs, and technology. In EM countries, our model likes Argentina, China, Hong Kong, Singapore, and Taiwan and dislikes Poland, Colombia, Brazil, Indonesia, and Peru. Among EM industries it likes metals and real estate and dislikes industrials, technology/media/telecom, utilities, and infrastructure. Our global rates model continues to forecast lower yield and a slightly flatter curve.

The rates view expressed in our G10 model portfolio is overweight global duration. It is overweight North America, underweight Europe, overweight Japan, and slightly overweight Australia. Along the curve, it still positions for flattening with overweights in 10-year and 20-year durations and underweights in five-year and 30-year durations.