Recent abrupt market moves, the U.S. economy stuck in a holding pattern, and a bumpy road ahead. Our response: to be even more intentional in our risk taking.
Market Thoughts: Holding the reins tight
- Data dependency is the current approach to monetary policy. The fallacy of ‘no landing’ for the global economy continues to stream from pundits. We’re going to land. It’s a question of when and how hard.
- The operative market question today is: “Are the flashpoints we’ve seen across the U.S. banking sector idiosyncratic or systemic?” I believe both. The root cause is the pace of rising interest rates.
- There is a lot being written about whether the U.S. Government will choose to default on its debt. That should never be a question. The tail risk is small, but real.
- Given market volatility, it’s an environment where we are being very intentional in our risk taking. Volatility can create opportunity. Untethered volatility can do the opposite.
With an ongoing tug of war between recessionists and optimists, some ‘fog of war’ has been lifting. But an all-clear bell isn’t ready to be rung. Macro data is volatile; so are markets. Investors still don’t know enough about what lies ahead. Trends are tough to read in a transitionary environment.
The fear of missing out had modestly crept back into the market narrative. The irony is that sidelined cash may keep a relative floor on how far markets correct. Have fun with family and friends. Ask who’s waiting to buy an equity market selloff. Then toss in “At what level?” My sense is most people will say 5-10% lower. It’s always 5-10% lower.
Range-bound is likely the right way to describe current markets. We’ve been trading the same broad ranges on the S&P 500 for most of this year. Sidelined cash may not let us re-test last October’s low unless something really goes wrong.
Helplessly hoping. Dogmatically data dependent is how I’d characterize the current approach to monetary policy. That, or “confusion has its cost.” It’s a line from Crosby, Stills & Nash’s song “Helplessly Hoping.” A fitting inflation fighting mantra.
The Federal Reserve (Fed) set itself up for a potential June pause in rate hikes. We’ll see. Their pace of tightening has been faster and more assertive than anything seen since the 1980s, with ten back-to-back hikes totaling 500bps in a little more than one year. We are back to policy rate levels last seen in 2007.
Not only does monetary policy act with a lag, but banks pulling back on credit is an added drag on the global economy, equating to more tightening. If I were sitting at the Fed, I’d hit pause in June. Time is on their side; they’ve done a lot of heavy lifting.
We continue to see inflation in cool down mode, but it’s still too high. Recent U.S. economic data showed wages strong yet coming off the boil. The same can be said more broadly for the labor market. The economy is slowing and in ‘OK’ shape. All of that is good news for the soft landing crowd. But it keeps the Fed keenly aware their fight against inflation is far from over.
Having hiked 25bps in May, the European Central Bank (ECB) left the door wide open for more rate hikes. Like the Fed, they have forcefully increased interest rates (Figure 1). The ECB has hiked 375bps in about a year. We are back to levels last seen in 2008.
Figure 1: The Fed and ECB have aggressively increased policy rates
Line chart as of May 2023 showing U.S. and euro area central bank policy rates shown in percentage terms on the y-axis with monthly data points since 2003 on the x-axis. A footnote details that for the euro area, the deposit facility rate is shown. Heading into 2005, the U.S. hiked forcefully to 5.3%; while the euro area started hiking in early 2006, reaching a peak rate of 3.3% by 2008. In 2009, policy rates hovered around zero for both regions. The euro area hiked to 0.8% in late 2011 while the U.S. remained steady. U.S. policy rates began to increase in 2016, realizing a peak of 2.4% by July 2019. However, euro area policy rates decreased over this period to -0.5% by late 2019. After hovering around or below zero since early 2020, policy rates have increased in both regions as their central banks aggressively hiked; with the U.S. at 5.1% and euro area 3.3% most recently.
The ECB has a single price stability mandate. The Fed’s dual mandate includes price stability and maximizing employment. If the Fed is on hold for June and the ECB presses on, the euro should retain its recent strength.
The fallacy of ‘no landing’ continues to stream from pundits. For anyone that’s ever ‘enjoyed’ being stuck on a plane in a holding pattern, circling is a better analogy than no landing for the economy. We’re going to land. It’s a question of when and how hard.
Idiosyncratic or systemic? To say the past few months have been a whirlwind for markets doesn’t begin to describe it. The operative question today is: “Are the flashpoints we’ve seen across the U.S. banking sector idiosyncratic or systemic?” I believe both.
The root cause—rising interest rates—is systemic. The issues that caused certain banks to fail appear idiosyncratic. But I don’t believe we’re done seeing smaller shocks to the system. I say that because of the pace with which rates have risen.
Investors recognize in a higher interest rate environment that bank balance sheets are liability sensitive. The key question? Whether the headlines and negative price action provoke renewed deposit outflows. That’s the perfect negative feedback loop for short sellers.
For all the bandying about of the word ‘crisis,’ we’re not in bank crisis mode. We’re stuck in a moment of rightful investor concern and banking sector driven stress. What we’re seeing feels more like the Savings & Loans (S&L) crisis in the 1980s than the 2007-2008 global financial crisis (GFC). That’s good and bad news. The S&L crisis proved a ‘slow-bleed’ on the economy. The GFC defined shock and awe.
Actions taken to date by regulators have signaled their willingness to do more, as needed. The moral hazard arguments being made about encouraging bad (or inept) bank management teams taking on risk at the expense of taxpayers is one that regulators and Washington will need to address.
A wild ride. At the start of this year I would have said the risk of recession in the U.S. was about one-third. After events the past few months, it’s a coin toss. If we get a series of added shocks to the banking system, the risk of a hard landing will quickly creep into scope. The macro data simply isn’t showing that currently. That can change.
We’re seeing a slowing global economy. As base case, I’m anchored on a narrow path to soft landing or a shallow recession. But the outlook is cloudy due to rising tail risks. I’m watching credit markets closely. They’ve been bumpy, but so far haven’t shown concern of a hard landing. They are, however, showing signs of modest stress. Credit markets are a dependable canary in the coalmine. So are banks.
Fixed income markets continue their wild ride. That said, risk assets remain supported. Big tech has driven U.S. equity market returns this year. We’re far from all-clear on risk assets. The steepness of the U.S. Government bond yield curve inversion remains dialed to levels not seen in over 40 years (Figure 2). Some of that is technically driven by trend following shorts forced to unwind positions. Some of it is fundamentally driven, based on a hard landing outlook.
Figure 2: U.S. Government bond yield curve remains deeply inverted
Line chart of the U.S. Government bond yield curve (defined as the U.S. 10 Year Treasury Bond – 3 Month Treasury-Bill yield spread) shown in basis points on the y-axis and displayed with monthly data points since 1981 through April 2023 on the x-axis. As of April 2023, the yield curve displays a deep inversion of -160bps, a level which hasn’t been seen since 1981. The dashed line indicates an average value of 168bps over the time period shown. Inversions were also seen in 1981 (inverted by -160bps), 1989 (-30bps), 2000 (-78bps), 2007 (-56bps) and 2019 (-48bps). Those prior inversions were followed by economic recessions as defined by NBER, which are indicated by shaded areas.
The economy is slowing, as is inflation. Jobs data remains hardy. The U.S. economy doesn’t look like it’s quickly slipping into recession. That’s good news for consumption and revenue growth. So far, it’s been good for corporate margins as well, which remain above historic levels.
I expect S&P 500 margins will continue to move back towards long-term trend levels, about 11% looking back ten years and 10% over the past twenty years. Margins currently hover right around 11.5%. They peaked in the first quarter of 2022 at around 13.5%.
Freight demand continues to trend lower along with supply chain activity. Broad commodity prices continue to roll over as well, especially energy and food. Central banks are getting what they’re after. The question is how much higher policy rates need to go before this tightening cycle ends.
Debt crisis redux. There is a lot being written about whether the U.S. Government will choose to default on its debt. I view a lot of that as headline filler. The debt ceiling will be increased. There is no choice. The question is how long this can be pushed out before markets push back.
To borrow a line from Jay Powell, we shouldn’t be talking about a world where the U.S. doesn’t pay its bills. That said, never is a word I stopped using after the 2007-2008 global financial crisis. Every nation needs to be mindful of its debt load. Debt levels globally are too high, including the U.S. They need serious address, not political theatre.
We are watching events unfold in Washington closely. The tail risk may be small, but it’s real. We’ve already seen U.S. Government credit default swaps (CDS) push out to levels we haven’t seen since 2011-2012. I’m keeping an eye on U.S. CDS as it’s something that shouldn’t move. When it does it reflects investor concern, hedging expected market turbulence ahead.
If things get pushed to the wire and markets truly become unhinged, we would likely be buyers of U.S. Government bonds and risk assets.
Holding the reins tight. Given the abrupt moves we’re seeing, it’s a market environment where we continue to be very intentional in our risk taking. Volatility can create opportunity. Untethered volatility can do the opposite. The volatility we’ve seen over the past year has weighed heavily on animal spirits (Figure 3). There simply isn’t trust in the near-term outlook… it’s going to take time to rebuild.
Figure 3: Markets experienced episodes of high volatility over the past year
Line chart of the VIX (left axis) and MOVE (right axis) Indexes shown in level terms on separate y-axes. The time series are displayed since 2017 through May 11th, 2023 on the x-axis; using daily data. From 2017 to early February 2020, the MOVE Index hovered between 40-90. In March of 2020, the VIX and MOVE Index each jumped to very high levels of 83 and 164, respectively. Since then, the VIX Index has generally been within 15-40. On the other hand, the MOVE Index again reached those very high levels in 2022, and remains elevated vs history. It reached an all-time high of 199 over the time period shown in March 2023.
We added earlier this year to European equities, funded from the U.S. I viewed that shift as defensive repositioning, with upside potential. Europe is attractively valued both to its own history as well as relative to the U.S. In a broad market pullback, I expect Europe’s lower valuation to provide better down-capture relative to the U.S. Should the global economy surprise positively, Europe offers an opportunity for further re-rating. It’s already run hard, helping year to date portfolio performance.
We retain a modest overweight in portfolios to extended credit. We’ve been trimming those positions since last year, adding to investment grade credit both in Europe and the U.S. We’ve been de-risking, moving up in credit quality. We’ve also added to longer maturity Government bonds last year as rates pressed higher.
Bonds are playing a key role as risk diversifiers in portfolios. Given the recent pullback in long-term interest rates, we’ve had some active discussions about our duration positioning both in multi-asset as well as fixed income portfolios.
With the outlook murky and markets on edge, we’re holding onto core bond duration. We’re better buyers of credit, especially investment grade (IG), should we see spreads gap out. Both European and U.S. IG aren’t attractive enough to lean further into. They’re on the shopping list.
We have a bumpy ride ahead. We’re not being paid to take big market bets. Recognizing the noise clouding the macro and market landscape, holding the reins tight on risk continues to feel like the right course of action.
INDEX DEFINITIONS
The S&P 500® is widely regarded as the best single gauge of large-cap U.S. equities. The index includes 500 leading companies and covers approximately 80% of available market capitalization.
The VIX Index is a calculation designed to produce a measure of constant, 30-day expected volatility of the U.S. stock market, derived from real-time, mid-quote prices of S&P 500® Index call and put options. On a global basis, it is one of the most recognized measures of volatility - widely reported by financial media and closely followed by a variety of market participants as a daily market indicator.
The ICE BofA MOVE Index is a yield curve weighted index of the normalized implied volatility on 1-month Treasury options. It is the weighted average of volatilities on the CT2, CT5, CT10 and CT30 (i.e., weighted average of 1m2y, 1m5y, 1m10y and 1m30y Treasury implied vols with weights of 20%, 20%, 40% and 20%, respectively).
