Core inflation rates remain sticky. Central banks are preparing investors for further interest rate hikes. We are reducing the underweight in equities, but remain cautious.
Manufacturing vs services
At first glance, things are not looking good for the global economy these days. In the US, the majority of market participants, like us, expect a (mild) recession this year despite currently robust macro data. The eurozone may still be in the middle of it. The latest purchasing managers’ indices show that the economy has probably hardly grown since the beginning of the year and the outlook also remains subdued. After the service sector had shown surprising robustness in recent months and the divergence with manufacturing had become ever greater, the first signs of weakness have now also become apparent here.
In the US, on the other hand, the service sector remained resilient also in June, while the manufacturing sector continued to lose momentum. What both regions have in common, however, is an easing in price components. In China, recent data have surprised negatively, to which the Chinese central bank has responded with monetary easing. Recent developments in Russia also showed unmistakably how unpredictable wars are and that geopolitical risks can flare up again at any time.
The encouraging message is that two key stumbling blocks for markets have now been removed: the US debt limit dispute and the exaggerated rate cut fantasies in the US money markets. Instead, the reality has now set in that the major central banks are likely to continue their path of interest rate hikes into the second half of the year. Rate cuts are now not expected until next year. However, this change of mind among market participants was only made possible by surprisingly aggressive rhetoric and unexpected interest rate hikes by some major central banks, first and foremost the Bank of England.
The US Federal Reserve, on the other hand, paused in June after 10 rate hikes in a row. However, there is still a long way to go before the inflation target of 2% is reached, according to Fed Chairman Powell. We expect two more rate hikes to follow by the end of the year. A surprisingly resilient US economy and a continued strong labour market pave the way for this.
Short-end vs long-end bonds
In this environment, yield curves on both sides of the Atlantic have continued to invert. The interest rate differential between two-year and 10-year US government bonds has now risen again to over 100bp. This indicates that the rates market already regards the current level as very restrictive. The inversion is primarily due to rising short-term interest rates. By contrast, the long end of the yield curve has remained relatively stable since October last year. Even in the environment of the US banking crisis, yield fluctuations remained limited. Yields on high-quality corporate bonds are currently at their highest level in more than a decade, both in the US and in Europe. Credit spreads on European investment grade bonds, at current levels close to the 2016 and 2018 highs, also offer sufficient cushion in the event of economic weakness. This is not the case for high-yield bonds, whose risk premium hardly compensates for expected default rates in the event of a mild recession.
Bond volatility vs equity volatility
The sentiment on the equities markets has recently changed for the better. Investors have become more optimistic and have increased their equity positions in recent weeks, after a long period of only observing the equities rally from the sidelines. However, the price increases themselves were hardly driven by earnings, but primarily by higher valuations. In this environment, the risk premium for equities recently declined further.
A particular feature of this year’s market behaviour is the low volatility that market participants are pricing into the equities markets, while it remains high in the bond market. Since October, the VIX index, a volatility measure for equities, has been trending steadily lower. In contrast, bond volatility remains elevated. The difference is higher than it has been since the beginning of 2008. Back then, equity volatility caught up with bond market volatility with a vengeance. Will it be different this time? That is difficult to predict. In any case, it would be much easier to buy into an equity rally if bond markets were also sending a supportive signal.
Patience vs opportunity cost
We had a preference for liquidity and high-quality bonds in the first half of the year. Not least because investors were attractively compensated for their patience in waiting for better opportunities to increase portfolio risk in a capital market environment characterized by high uncertainty. The price increases in equities, especially in certain sub-segments, have repeatedly put this patience to the test. But on the monetary and macroeconomic front, things have largely turned out as expected: (core) inflation remains stubbornly high, central banks have to remain restrictive for longer, economic growth at the global level is slowing, and the sharp rise in interest rates over the past twelve months has left significant collateral damage in the banking sector, with the full effects likely to unfold only in the coming months anyway. And the longer the cycle of rate hikes continues, the greater the risks of adverse effects on the economy and financial markets.
Although we note that the economic environment is more robust than expected and that a US recession is likely to be milder than we previously forecasted, we expect the rise in short-term interest rates and tighter credit conditions to take their toll. Corporate margins are likely to come under pressure over the course of the year, weighing on earnings and ultimately equity markets. We therefore remain patient and maintain our underweight, but have reduced it slightly.
In our view, a still restrictive interest rate environment continues to favour fixed income securities in the bond market, especially shorter maturities and bonds with high credit ratings. We also see attractive opportunities in emerging market bonds on a selective basis. We remain overweight in alternative investments and gold due to the positive diversification contribution.
Philipp Baertschi is CIO at J Safra Sarasin Sustainable Asset Management.
This story first appeared on our sister publication, Portfolio Adviser.
