Reality will bite for central banks

As we look forward to the second half of 2023, we expect central banks to finally turn the corner on monetary policy and start to be worried far more about growth than inflation.

Central banks, guided as they are by their main KPIs of managing inflation and unemployment, are having their policy action dictated by two of the most lagging indicators it is possible to find. It is the equivalent of driving a car while looking in the rear-view mirror. But if we look forward out the windscreen, there are a range of leading indicators pointing towards recession.

Money supply growth in the US is deeply negative, deeper than at any time since the 1930s in fact, and this historically has been strongly associated with recessions. Elsewhere, the excess savings which have supported consumption for the past couple of years have now been virtually exhausted, elevated mortgage rates are leading to housing market stagnation, while the S&P 500 has seen negative earnings for two consecutive quarters and CEOs therefore might think hard about their cost base, with the obvious implications for unemployment.

So is the US headed for recession? Whether or not it enters a technical recession is anyone’s guess, but we certainly feel strongly that the idea of the US economy experiencing a soft landing is wishful thinking at this point. Policy has tightened so much, and so quickly, that it has not yet fully fed through into the real economy. Even if the Fed halted rate rises today (and their rhetoric suggests they might still have one rise left in them before reality bites) then the economy would still keep feeling the impact of that tightening for months to come.

An environment in which inflation keeps rolling over, growth falters, and the employment picture worsens is one in which continued hawkish policy from the Federal Reserve will rapidly become untenable and cuts will follow. In our view this lays the foundation for an extremely promising investment environment for fixed income.

The investment opportunity, as we see it, is an enticing one. As we come off the back of one of the worst bond market sell-offs in history, valuations especially in government bonds have gone from expensive to very cheap in our opinion. Away from the world of government bonds, our economic outlook means we have been getting more cautious on credit in aggregate. Credit markets, led by the high yield market, have continued to perform pretty well, but they are not yet pricing in the slowdown that we foresee. But that doesn’t mean credit is without opportunities! However, our preference is for the more defensive sectors, secured structures and bonds with shorter maturities or nearer term call dates.

We have a high level of conviction in our macro view, but of course we know that nothing is guaranteed and there are factors which could de-rail the world from this path, including China generating a rapid economic turnaround, governments stepping in to shield the public from the impact of higher rates (e.g., mortgage rate relief), and a new spike in food price inflation perhaps driven by adverse weather or Russia/Ukraine abandoning existing grain agreements. The world is an unpredictable and volatile place, as we’ve all had ample evidence of in recent years. But the vast breadth of fixed income asset classes available means we have confidence that, whatever fate throws at bond markets, a flexible and dynamic global bond portfolio should have the tools at its disposal to meet that challenge.