Investment Strategy Insights: Will Industrials Manufacture a Recession?

Stance: While wage growth remains robust at 4.4%, the US labor market is showing signs of a slight slowdown, with non-farm payroll gains falling below 200,000. Despite the deceleration, labor market growth remains above its neutral rate, likely providing a tailwind to the US economy even if it gradually weakens. The advanced estimate of second-quarter US GDP pleasantly surprised to the upside, reaching 2.4%, while the widely used (if unofficial) Atlanta Fed GDPNow forecast was revised to 5.8% year-over-year for the third quarter. Robust growth, along with the potential for even more substantial expansion, contradicts the earlier market consensus that the latter half of 2023 would witness significant economic weakness.

While concerns about lagging monetary policy persist, with many commercial and industrial lenders tightening credit and consumer credit delinquencies edging upward (albeit from a low starting point), the broad economy appears robust. In addition to the strong labor market, retail sales have exceeded expectations and the housing market is stabilizing. As the broader market’s apprehensions about growth recede, the factor driving Fed behavior is likely to pivot back to inflation. Though core inflation is experiencing a gradual descent, overarching dynamics remain entrenched, particularly within services. Headline inflation is beginning to climb higher as the tailwinds from base effects taper off and more challenging month-on-month comparisons come into play.

Japan took center stage this month as the Bank of Japan shifted policy and expanded the parameters around its 10-year yield target, essentially allowing rates to drift upward. Unlike most G10 central banks, the BOJ actively hopes for an inflation uptick and is likely focusing on wage growth as an indicator of sustainable domestically driven inflation. The bank will attempt to balance stimulating domestic inflation and wage growth with managing the yen’s volatility and imported inflation.

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; 3) more resilient economic fundamentals across Europe and the US.

Our rates team warned that August would be difficult, with massive amounts of issuance and few buyers, resulting in a drop in bond prices similar to what occurred during the last two weeks of 2022. As of mid-August, that negativity has been warranted: in terms of returns, the month has been worse than expected, and risks on the downside continue to outweigh risks on the upside. After Fitch’s early-August downgrade of the US to AA+, will the higher-rated countries – Canada, the Netherlands, Australia, Germany, Sweden, Norway, and Singapore, all still AAA – continue to buy US debt or demand more of a premium to do so? Late in August, rumors swirled of China and Japan having difficulty and possibly selling bonds or dollars to shore up their respective currencies. Whether or not that is true doesn’t matter; it’s enough to keep buyers out of the market.

While the US economy and corporate earnings have surprised to the upside – in contrast to other regions, notably China, which having disappointed to the downside – the negative impact from rate hikes is expected to be more apparent over the next 12 months as some of the fiscal stimulus expires. Overall, the risk of recession is lower, and more important, any recession that does occur is expected to be much milder than anticipated at the start of the year. Unfortunately, that less-negative credit outlook is now fully reflected in credit spreads; high yield (HY) is trading into the 370s, and investment grade (IG) is in the 110s. Spreads are at or through our near-term range and we are therefore maintaining our defensive bias within portfolios. However, since our base case is that we will be in a coupon-clipping environment in the months ahead, we prefer higher-yielding loans and high yield bonds over investment grade despite the conviction score. Credit market strength for solid issuers has resulted in a pickup in new issuance beyond refinancing transactions. The market even has seen some dividend transactions, although new leveraged buyout volumes remain muted. The growth in private credit funds has also provided ongoing support for the market. Emerging market (EM) sentiment remains negative, particularly as it relates to China, and recent political risk in Argentina and Ecuador may broaden the negative bias. While Latin American central banks have commenced rate cuts, which should be supportive, we would not currently add risk until valuations become relatively more attractive.

A tilt in short-term fundamentals has become more favorable toward the US dollar. This is most apparent in the widening gulf between the US and euro area Economic Surprise Indices, largely due to recent European underperformance. One explanation for the growing disparity is that European manufacturers are more dependent on China’s economic fortunes than are manufacturers in the relatively more closed US economy. This gap, however, is expected to fade over the next 12 months.

Monetary policy acting with a lag appears to be gaining traction in the latest US CPI releases. While labor market data, strong growth projections, and fiscal spending from earlier in the year remain headaches for the Fed, financial markets have started to price in a Fed peak. We expect to see weaker US economic data filtering through later in the year. This should prove to be a negative for the US dollar. The euro/US dollar relationship has been incredibly sensitive to shifts in the front-yield curve as a proxy for monetary policy. Since US exceptionalism is expected to ebb, the Fed may cut interest rates sooner than the European Central Bank.

Since most long-term models suggest the US dollar is overvalued, we tend to favor a weaker US dollar trend over the longer term, perhaps starting in the fourth quarter. Despite the US dollar gaining traction against the euro and G10 pairs in the short term, we don’t see this derailing the positive EM foreign exchange (FX) story. Rapid disinflation among many EM countries and positive real policy yields will continue to support EM currencies. We expect EM FX to remain stable in the first part of their rate-cutting cycle. Falling front-end nominal yields and attractive real yields will continue to gain inflow from investors, who remain underweight EM FX compared to historical allocations.

Emerging markets have become increasingly sensitive to US Treasury moves as IG and HY spreads have compressed significantly. We see negative excess returns in many scenarios due to markets already pricing in bottom-up forecasts that indicate improving fundamentals. In this Goldilocks environment for global credit, in which spreads can get pushed tighter unjustified by fundamentals, we advocate being selective, especially as rising financing costs raise the question of market access and debt sustainability in connection with refinancings. In 2017-2018, average yields for B rated credits were roughly 7%, versus 11% today. With the exception of Turkey, Egypt, Argentina, and Tunisia, most EM countries with chunky redemptions should be able to easily refinance through the market (external or local). Those exceptions, however, warrant close monitoring for the magnitude of their multilateral debt access.

Debt sustainability is a good predictor of credits that will become distressed, and the rates/growth ratio is a good measure of sustainability: When interest rates consistently outpace growth, debt service becomes unsustainable. For 21 credits in our universe, interest rates are higher than growth, which means they must either run significant primary surpluses or increase involvement of multilateral funds, such as the International Monetary Fund. In EM corporate debt excluding China and Russia, default expectations are remarkably low at 1.5%. Add in those two nations, and the overall level of defaults is expected to be around 5.6%, yet that does not include a possible default by troubled Chinese real estate company Country Garden. While the market seems to be pricing a soft landing in a higher-for-longer/no recession scenario, we still assign a 55% probability to a recession setting in over the next 12 months as a result of monetary policy acting with a lag.

While consumption was robust in the initial stages of China’s reopening, it has since flatlined. The recovery is uneven, with sluggish private investment, weak exports, and a stagnant housing market. These challenges pose a risk to local government finances and call for urgent, substantive support from the central government. China’s highly anticipated Politburo meeting recognized the problems and communicated the need to strengthen countercyclical policies and build buffers against risks in certain key sectors. China’s reopening now enters a new phase, marked by a policy mix shift featuring more infrastructure support, meaningful regulatory relief, targeted support in property construction, and stimulus to boost consumption in areas that support advanced manufacturing. After a prior decade of monetary restraint to fend off a property bubble, today’s low inflation and teetering housing prices lead us to expect ongoing monetary easing geared to mitigate property price declines and potential balance sheet risks from local governments.

Meanwhile, in Japan we see a pivotal shift to monetary tightening. This is the beginning of the end of free money in Japan, which will also mark the end of free money in developed markets. Due to these changes, we favor inexpensive markets where policies have shifted from a restraining to a nurturing posture. We maintain our “Go East” preference within the context of a still-cautious score of 3.5, given expensive markets and restrictive policies in the West, and also favor thematic leanings centered on productivity and climate related investments.

Consumer spending and labor markets are holding up well. Companies continue to feel good about their near-term visibility, though they are uncertain about 2024. Supply chains are better, which is helping end customers but causing some de-stocking issues. We are still finding opportunities to upgrade the portfolio and invest in advantaged companies at valuations below typically high levels. The lack of market breadth and the existence of various mini-cycles across sectors are helping in this regard. We remain overweight in industrials but have reduced exposure, as the group continues to trade at peak multiples based on earnings estimates that are at risk of downward revisions as orders decelerate and companies work off the strong backlogs they have built over the past few years.

In China, smartphone supply-chain companies continue to see weak end-demand globally, fewer spec upgrades, and competition to fill capacity. Credit card data and new orders indicate spending on furniture is stabilizing. Douyin, China’s TikTok app, continued to gain market share from traditional e-commerce players, and its second-quarter results have been in line with expectations or slightly better. Generally, companies that outperformed showed good cost control or other non-topline drivers. Meanwhile, low valuations no longer warrant a sizable underweight, as in previous months, but more moderate positioning. In India, results for the June quarter have been broadly as expected. Banks generally did well, with growth in loan books, mixed asset quality, and slight margin compression. Tech companies reported a slowdown in revenue due to pressure on global IT budgets. Indonesia’s economy continues to do well, with banks reporting good results.

In Latin America, Brazil and Mexico are reporting strong results across several sectors. In emerging Europe, after 13 years of austerity and reform, Greece is now one notch away from an investment grade rating. CE3 economies are mixed, although some companies are doing well for idiosyncratic reasons. Turkey rallied 18% in July in US dollar terms on the hopes of economic stabilization, but we are not trying to catch this move and see it more as a trade. South Africa continues to suffer from multiple problems even though its market also did well recently.

EM generally appears once again to be in a period of slower topline growth, where profits will be driven by cost control, the revenue mix, and economies of scale. Margins also will be helped by foreign sales, especially in countries including China where the currency is weakening and is thus supportive of exporter profitability.

Our US Conviction Score improved to 4.12, driven by a steeper curve (+14 basis points) and tighter BBB credit spreads (-14 bps). Amid negative global credit forecasts, our model slightly favors emerging over developed markets. In DM, our model favors industrials, technology, finance companies, transportation, and capital goods, and dislikes communications, electric companies, utilities, and REITs. Among EM industries, our model likes transportation, financials, and oil and gas. It dislikes real estate, utilities, and metals. Our global rates model forecasts lower yields globally and a flatter curve in the UK, Oceania, Norway, and Japan. It forecasts a steeper curve in the US, Canada, and Switzerland. The rates view expressed in our G10 model portfolio is overweight global duration. It is overweight North America and Japan, and underweight Europe. Along the curve, it remains overweight in the two-year and 20-year and underweight in the five-, 10-, and 30-year.