The macro outlook has changed significantly – is a recession upon us?
This time last year markets had suffered considerably due to spiralling inflation, which led to one of the most aggressive hiking cycles on record. Consequently, markets had performed poorly across most asset classes.
Fast forward 12 months and 2023 might not feel like a great year either. Looking at the rates market, rates are still providing headwinds, central banks have still been hiking rates and inflation is yet to be under complete control. However, we do believe that we have made considerable progress.
Various parts of the fixed income markets have performed very well this year and it is those higher yielding areas that give you a lot of carry. But we are now facing different challenges and market participants are questioning whether a hard landing can be avoided.
Further to this, the focus of late has increasingly been on the ‘lag’ of the monetary policy effects and what kind of landing can be orchestrated by central banks. Whilst we believe the clues are in the data, we also see the quantification of this lag to be an important consideration.
Looking at economic data, this time last year global GDP was bouncing around zero and the outlook felt quite negative at the time. We also felt that the aggressive rate hiking cycle that we were seeing would possibly result in a recession in a short space of time. However that has not been the case and global economies have been much more resilient than we might have expected. To this point, international bodies, such as the IMF and OECD, have upgraded their outlook for global growth. Having said that, both the growth we’ve seen and the growth expectations going forwards are still lower than we would hope for though.
Regarding inflation, the biggest issue that investors have had over the last 18 months is the sheer volume of rate hikes implemented by central banks across the board in their attempt to control decade-high inflation; we believe that the Fed should be done at this stage, whilst we may see another hike or two from the BoE and ECB.
Despite a weakening in global economies, expectations for a “soft-landing” in the UK, the US and Europe are still very strong, and this is where we think the soft-landing narrative is coming from. We have had a ‘soft-ish landing’ base case for quite a while now so while we think that the respective economies will flirt with the idea of a recession, we do not believe it will be a hard landing.
Having said that, it is evident that rates headwinds certainly do not help investors in fixed income. When looking at investment grade returns, they really have been a lot lower than what was expected. If we were to look back to 2008, for instance, the last time we had a reasonably poor year for investment grade, investors got that performance back the following year. This time round that has not been the case, however we do think that this is delayed performance and that it will still come.
In High Yield, however, the yield that we had at the start of the year has certainly protected this market better than one would have expected. Considering the rates headwinds, a continuing war, the US regional banking crisis and the collapse of Credit Suisse, performance has been very strong.
Unsurprisingly, AT1s have struggled and have experienced a very volatile period given the US regional banking crisis and the subsequent fallout of Credit Suisse. Whilst the sector saw material losses, the fact that the AT1 index has clawed back those losses and is now almost flat year to date is rather impressive in our view. However, it is still very disappointing that a sector like this, which we think should have delivered great performance, has been so poor this year compared to say High Yield. But again, we do believe that this is delayed performance as opposed to eliminated performance.
Regarding banks and insurance, this is one area where spreads have not come in that much and are still very close to their wides. However, again we do believe that performance will come true as we believe that the yields available in financials are incredibly attractive given the strong fundamentals across both the banking and insurance sectors.
When it comes to rates, we believe that the Fed is done whilst being cognisant that there is a possibility, albeit we think a small one, of another rate rise. History tells us that when we see the last rate rise, that is when investors should be buying treasuries as this is when they are at their cheapest. And certainly, at the yields on offer, we think they look attractive.
The story is slightly different in Europe and the UK. In Europe, we have not had any material movement in the rate curve for European government bonds since the start of the year, which is somewhat surprising, although we think this just feeds into the fact that Europe is a more complicated area. In the UK, however, Gilts have continued to move significantly higher. Given the persistence of inflation in the UK, this probably does not come as a surprise.
We do believe that base rate hikes in the US should be in pause-mode and have likely concluded their hiking cycle, but we are wary of how much damage has been done. In Europe, markets are hopeful that the ECB is also close to the end of its hiking cycle, however, core CPI remains still too high for this to be a given. In Asia, China has emerged from its zero-Covid policy much slower than expected and, consequently, this has had a negative impact on global demand and growth.
In conclusion, inflation now finally looks to be at a reasonable level and the continued fall towards central bank targets will be welcomed by market participants. Rates headwinds will end in 2024 regardless of whether we see rate cuts or not and, consequently, we think interest rate duration is likely to be more supportive going forward. We are cognisant that we appear to be in a late cycle environment and that external shocks could potentially tip the economy into a recession, however, we do not expect a hard landing.
And so, for investors, we believe there can be no doubt that the high yields on offer within fixed income markets look attractive and are well placed to produce attractive positive returns over the medium-term.