Investment Strategy Insights: A Shallower But Prolonged Credit Default Cycle May Lie Ahead

Stance: The Federal Reserve has paused its rate hikes but maintains its hawkishness by assuring the market that one or two more increases are coming before the end of 2023. Despite tight financial conditions, US labor markets are still strong. Jobless claims remain below levels that would indicate an imminent economic slowdown, and non-farm payrolls continue to surpass expectations, keeping the overall outlook robust. Inflation remains persistent, particularly in core components, but has been declining gradually, with the shelter component of the Consumer Price Index (CPI) showing convincing signs of decreasing and the services sector starting to trend lower. This decline in inflation, coupled with higher-than-anticipated wage growth, has resulted in positive real wage growth for the first time since 2021. Although the broader growth environment is not exceptionally strong, it also has not experienced a significant slowdown. Retail sales for April and May showed month-on-month increases of 0.3%, indicating a moderate level of economic activity that while not strong enough to prompt talk of a reacceleration does support the idea that substantial savings and steady wage growth have provided a short-term cushion against monetary tightening.

Elsewhere eurozone inflation data have been favorable for the European Central Bank (ECB), but concerns about a tight labor market, rising wages, and increasing inflation expectations have kept the bank’s overall narrative somewhat hawkish despite indications that economic growth is beginning to slow. China’s growth has been less robust than expected, particularly in the manufacturing sector. As a result, stimulus packages have been introduced to support the economic recovery. This aligns with the view that the reopening of economies will be uneven but ultimately successful.

Risks: Inflation falling faster than expected or the Fed looking through services inflation and pivoting earlier; systemic issues in either Europe or the US; more resilient economic fundamentals across Europe and the US.

With T-bills now yielding more than SOFR, the Overnight Reverse Repo facility no longer provides the highest yield on the US Treasury curve. The bond market, having slogged through the debt-limit and bank-failure crises, can return to its pre-crisis levels, which were 5.09% on the two-year note and 4.08% on the 10-year. The levels probably need to be adjusted higher given where Fed funds have moved. The ECB has raised rates since our last meeting and Madame Lagarde, baking in a July hike to combat inflation, is decidedly more hawkish than Fed Chairman Jerome Powell. T-bills should yield increasingly more if the US Treasury sticks to its cash replenishment plan by issuing an enormous volume of them in the future. Liquidity will be thin through the rest of the summer as rates move higher.

Valuations have continued to grind tighter, particularly in high yield (HY) bonds as spreads are on the cusp of +400 once again. While we expect a very mild recession or a soft landing due to employment strength, the tight valuations call for moving our score to a slightly more defensive level. With the BB-BBB differential tightening to +100, we would prefer to be in investment grade (IG) over HY at the asset class level, although attractive security selection opportunities still exist in the single-B space. With the Fed and ECB signaling to markets that they do not intend to shift to a new easing cycle anytime soon, the impact of their tightening is starting to filter into the economy and inflation is trending down, but low unemployment and strong financial markets counter fears of quickly decelerating economies. Absent a severe economic downturn or a market shock rivaling the global financial crisis — a very low probability scenario — we believe the hyperbolic default forecasts by some strategists are substantially overstated. Instead, we expect a return to long-term historical averages after several years of ultra-low defaults.

Policy rate and growth differentials remain the key currency drivers for the medium term. While we have scaled back optimism that the ECB can go it alone in tightening monetary policy, forward-looking indicators suggest that it will stay hawkish for a little while longer than the Fed. Ultimately, the shrinking policy rate differential should support a stronger euro, just not to the same extent we believed last month due to eurozone growth slowing more quickly than anticipated. A tug of war persists between “higher for longer” and “monetary policy acting with a lag,” yet the Fed is getting closer to the peak and the current pause may extend longer than expected , eroding the broader support for the US dollar. Since US exceptionalism is expected to fade over the next 12 months and because most long-term valuation models suggest the US dollar is overvalued, we expect the weakening US dollar trend to persist. Cyclically, it is also overdue a correction. We have noticed that weaker oil prices are affecting the terms of trade in favor of the euro, reversing last year’s trend. An uneven growth recovery and lack of policy response hurt sentiment in China in the second quarter, yet its 5% annual growth is still better than other major economies, supporting a widening in the emerging market (EM)/developed market (DM) growth differential. EM currencies offer better valuations and a clearer path toward monetary policy easing to sustain economic growth than their G10 counterparts.

While coincident indicators in the US remain better than expected, leading indicators signal a significant downturn. A Fed pause would be preferable for investors, but credit markets are likely to ignore further Fed hikes as long as growth is on track for a mild recession (possibly the most well-flagged downturn in history). Labor market resilience continues to surprise, but recent jobless claims show tentative signs of an upward move, which could be a turning point. Excluding employment, the US economy shows signs of drifting into recession. Surprisingly, lagging factors such as monetary policy tightening and declining loan demand have been offset by credit card spending, excess savings, and extraordinary and surprising fiscal spending. The Fed reaction as a data-dependent and backward-looking institution will be subject to developments in employment as well as sticky core inflation. Meanwhile, headline CPI inflation will be below 3% in July. The conclusion? Credit markets including EM credit can withstand a mild and well-advertised recession due to disposable personal income benefitting from labor market stability. Mexico could be the biggest beneficiary from a milder-than-expected US slowdown. Buffers are already in place within the economy for a recession, and companies are showing great resilience. All of this reaffirms our “classical” scenario (with a 55% probability) of a US recession/DM slowdown without sudden need for the Fed to provide extraordinary rate cuts. Our stagflation, pivot, and soft-landing scenarios have probabilities of 10%, 25%, and 10%, respectively.

China’s much faster-than-expected first-quarter growth sparked excitement until April’s economic indicators gave back unexpected ground, igniting concerns about the sustainability of China’s recovery. From the outset, policymakers have been attempting a service-based recovery with restrained stimulus. China’s policy mix has consisted largely of easing up on prior regulatory restraints. We expect more of this, along with some anticipated rate cuts, weakness in the yuan, and a modest increase in infrastructure spending. As a result, we believe the recovery in China, which is only six months old, will be more enduring than most expect, albeit shallower than what we have seen elsewhere. We believe that by year-end, China will be viewed as the “least-dirty shirt” of the major global economies. Meanwhile, the Fed may raise capital requirements for US banks by up to 20%, according to press reports, rendering growth tougher to finance. With the debt-ceiling crisis averted, the US Treasury must now issue upwards of $1 trillion, which will drain liquidity from financial markets. Saudi Arabia has just announced a 1 million barrel/day cutback in oil supply. As we transition into a phase of slower global growth, we maintain our cautious score.

We remain bullish on generative artificial intelligence (AI) opportunities in semiconductors and hardware but cautious on companies trading at high multiples that have a low mix of AI-related revenues. While big tech names have been leading the rally and are cited as the most crowded trades in the US, we remain selectively positive on specific stocks while being underweight the group due to valuation. In healthcare, we are overweight healthcare equipment and services as demand for healthcare services returns to normalized levels post-pandemic. We remain overweight life sciences companies as we anticipate the end of an inventory destocking phase and negative revisions as they work off Covid-related inventories and safety stock. We remain overweight in industrials but have reduced our exposure over the past month as the group continues to trade at peak multiples on earnings estimates that are at risk of downward revisions as orders decelerate and strong backlogs built over the past few years are worked off.