Fitch’s surprising downgrade of U.S. government debt early in the week sparked a wave of risk-off market moves and pushed yields higher. The move to downgrade the U.S government’s credit rating from AA+ to AAA was cited by Fitch as due to expected fiscal deterioration, a high government debt burden, and governance issues regarding repeated debt limit standoffs. On the following trading day, U.S. equities notched their worst day since April, and 10-year U.S. Treasury yields hit their highest levels since last November.
We think the downgrade primarily reflects long-term challenges around the large and growing stock of U.S. government debt, rather than new risks or information. It seems unlikely that this development itself will have a large or lasting impact on markets. Given the precedence of 2011 and the economy’s current resilience, markets seem to have stayed relatively calm. Having said that, the downgrade came just ahead of the August Treasury Refunding announcement, which showed an unexpected increase in Treasury issuance through year-end (~300bn more borrowing than consensus expectations). We’d also note that credit conditions are tight and treasury market liquidity remains poor, meaning there’s less room for error.
From here, we think there are two things to watch. First, because many money market and investment funds have a mandate on the types of securities (in part defined by their credit risk) that they can hold, does the downgrade create any forced selling of Treasuries. As of now, most believe this isn’t a major concern. Because Treasury securities are so important, most investment mandates and regulatory regimes refer to them specifically, rather than a more general requirement for “AAA-rated government debt.” And if 2011 is any example, while the impact on sentiment was tough, there wasn’t obvious forced selling at that time. The second dynamic to watch is the impact on yields. Concerns about the downgrade and increased Treasury supply has caused yields to move higher. As the conversation shifts towards concerns on U.S. government debt sustainability particularly as the election cycle heats up, It’s unclear whether these factors will nudge yields sustainably higher.
- Our high-conviction investment ideas include: long-duration fixed income, equal weighted S&P 500 and mid-cap equities, and private credit.
- Risk asset prices continued to rally in July. However, small- and mid-cap stocks outperformed large cap stocks, a notable broadening in the year-to-date equity rally. There’s exuberance in some places, but not in most places.
- We have been too bearish on the US economy; soft(er) landing probabilities have increased. Wages and trend inflation have slowed without significant weakness in the economy or material layoffs. Slower trend inflation suggests the depth and length of the economic slowdown ahead is likely to be shallower and shorter than previously expected.
- Revising higher our S&P 500 outlook; consider the equal weight S&P 500. With a more optimistic macro-outlook and better guidance from CEOs we expect more earnings growth in 2023 and 2024. We now expect the S&P 500 to reach 4800-4900 by mid-2024.
- We still like core bonds, even if a less meaningful economic slowdown means less near-term downside for yields. Historically, duration outperforms cash after the Federal Reserve reaches the end of its hiking cycle. Bonds can offer good income in our core scenario and protection in a downside scenario. For those looking for even more income, consider private credit.
- European equities have done well this year; going forward, we expect Europe to perform in-line with the U.S. at the index level (previously we expected Europe to outperform).
We have been too bearish on the US economy; soft(er) landing probabilities have increased. In overly simplistic terms, Wall Street economists assign a ~65% probability of recession due to the fact that the Fed has hiked significantly and the labor market is perceived to be tight, suggesting layoffs are likely necessary to bring inflation sustainably down to the Fed’s 2% mandate1. In addition these models factor in the inverted yield curve.
So why has growth been so resilient to Fed hikes so far? We think the biggest factors are: 1) the deployment of excess savings that built up during the pandemic, 2) lower interest rate sensitivity for consumers and businesses after they locked in low funding rates post-COVID and 3) the most ambitious US industrial policy project since the Cold War era.
Despite still strong growth, inflation has decelerated. A shift towards more permanent work from home arrangement has been enticing for workers – prime age labor force participation is above pre-COVID levels, and most notably for women. In addition, immigration has accelerated and is approaching pre-COVID trends. With more supply of workers, wages and trend inflation have slowed without significant weakness in the economy and/or material layoffs2. We note this increase in labor supply has been a key surprise factor that has allowed inflation to fall without a corresponding sharp growth slowdown. Core services ex shelter, the Fed’s proxy for trend inflation, has slowed from >4% last quarter to ~3% today.
Historically, when inflation is above 4%, developed market central banks have caused deeper recessions than when inflation is below 4%. That means this recent shift down in trend inflation suggests the depth and length of the economic slowdown ahead is likely to be shallower and shorter than previously expected.
Macro scenarios are still highly uncertain, but our new base case is a growth slowdown vs. a recession prior. We now expect two quarters of slightly negative growth in the first half of 2024 that pushes the unemployment rate up to ~4.25%.
The S&P 500 now trades at ~19.5x the consensus for the next 12-month price to earnings ratio (NTM P/E) vs. an average of 17.5x over the last 10 years. If you exclude the seven largest stocks from the S&P 500, the “magnificent 7”, NTM P/E multiples are still below their trailing 10-year average – hardly exuberant. Meanwhile, in July the information technology sector made a new post-Covid high valuation of ~29x NTM P/E – and this may be exuberance.
In credit, U.S. investment grade (IG) and high yield (HY) spreads are in the 19th and 12th percentile respectively, relative to spreads since 2010. Said differently, HY spreads have been wider 88% of the time over the last 13 years, which is insufficient compensation for the risk. Spread percentiles are meaningfully wider in Europe.
As we revise our S&P 500 outlook higher, consider equal weight S&P 500 strategies. On the back of a more optimistic macro-outlook (more expected corporate earnings growth potential) and better guidance from CEOs, we now expect the S&P 500 to reach 4800-4900 by mid-2024 (vs. 4450-4550 prior). While we expect new all-time highs within the next year, the S&P 500 has rallied ~19% YTD, so hesitation towards adding here is natural. However, the performance has been heavily concentrated in the “magnificent 7”, while the other 493 firms have lagged. Here is what you can get by considering equal weight S&P 500 strategies:
- Less tech and communication services, and more industrials – one of our preferred sectors given the cyclical and structural tailwinds. On a cyclical basis, earnings per share revisions for industrials are improving, with supply chain issues abating and revenues resilient in the face of higher interest rates. On a structural basis, public spending is a multi-year tailwind. The three recent fiscal policy bills include almost $2.4 trillion in funding, which should be a boon to industrial company revenues.
- Attractive valuations, but a higher expected growth rate. NTM P/E multiples for the magnificent 7 are near all-time highs, while the other 493 firms trade below their historical multiples. The equal weighted S&P 500 is one of the most attractive relative to the market cap weighted S&P 500 since the depths of the pandemic. Despite being attractive, we expect higher earnings growth in the equal weighted S&P 500 for 2023. Looking out to 2024, we expect earnings growth in the equal weighted S&P 500 to keep pace with the market cap weighted index.
We still see a logic in buying and owning core duration, even if a less meaningful economic slowdown means less near-term downside for yields. Our base case is the Fed will likely now be on pause with its rate hikes until Q1 2024, at which point they can start methodically cutting rates to a less restrictive level amid the growth slowdown. Under our base case, the Fed funds rate will likely exceed year-over-year core inflation by 250 bps in 1Q 2024 compared to ~100bps now. Said differently, the Fed could cut rates by 150bps at that point, and their policy stance would likely still be as restrictive as it is today.
Compared to our prior expectations, however, we believe the speed and depth of those cuts is likely to be slower and shallower, with the Fed funds rate reaching a target range of 4.50-4.75% by the middle of next year (vs. 3.25-3.50% previously). Translating this outlook farther out the curve, we now see the 10yr Treasury yield at 3.25% at mid-2024 vs. 2.95% previously.
We believe simple pillars still apply to consider adding duration:
- If you like cash rates today, consider locking in those yields for a longer time horizon.
- Historically, duration tends to outperform cash after the last Fed rate hike.
With credit spreads tight in public markets, consider private credit – where we think investors are compensated for the risk. Private credit is a strategy that invests in loans, bonds and credit instruments that are generally not tradeable. Secular changes in bank regulations post-Global Financial Crisis (GFC) and bespoke lending terms that benefit both borrowers and investors have driven the growth in private credit. Our Long-Term Capital Market Assumptions3 expect nearly 8% expected returns over a strategic 10- to 15-year horizon. Furthermore, we think investors are compensated for the risk of a near term recession in recent loan vintages. Here we rely on the J.P. Morgan Investment bank private credit financing team; we estimate that they see >50% of all direct lending deal flow, affording a unique perspective to direct lending fundamentals.
Protections afforded to private credit lenders are robust and growing. A majority of JPM’s financing deals have covenants vs. nearly 80% of new leverage loan deals which have no covenants.
European equities have done well this year; going forward, we expect Europe to perform in line with the U.S. at the index level (previously we expected Europe to outperform). Year to date, the SXXP Index is up 17% in USD-terms. Meanwhile, the SX5E Index, Europe’s 50 largest companies, is up 25% in USD-terms. Relative valuations are still attractive. Europe is now trading at around 12x NTM P/E ratio. Relative to the S&P 500, the discount is 40% vs 20% long-term average. The discount is now larger than during the Global Financial Crisis or European debt crisis. However, a few things are turning more negative -- European economic momentum has slowed more than we expected, and negative earnings revisions are coming and the boost from the currency has eroded.
The most recent data shows long-standing weakness in manufacturing starting to bleed into the services sector. As a result, this month we revised modestly lower our real GDP trajectory for the Eurozone even as we upgraded our outlook on the U.S.. We are below consensus for 2023-2025 earnings expectations.
1Since 1960, there have been 50 developed market cases of monetary policy tightening of 200bps or more. Relative to a similar point in the tightening cycle as we are today, 78% of the cases resulted in a recession over the next year and 92% over the subsequent two years.
2Core services excluding shelter is highly correlated to wage inflation, so a lower core services excluding shelter inflation rate suggests the labor market is not as tight as previously expected.
3J.P. Morgan Long Term Capital Market Assumptions. Data as of January 1, 2023.
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The Bloomberg Global Aggregate Index provides a broad-based measure of the global investment grade fixed-rate debt markets. The Global Aggregate Index contains three major components: the U.S. Aggregate (USD 300mn), the Pan-European Aggregate (EUR 300mn), and the Asian-Pacific Aggregate Index (JPY 35bn). In addition to securities from these three benchmarks (94.1% of the overall Global Aggregate market value as of December 31, 2009), the Global Aggregate Index includes Global Treasury, Eurodollar (USD 300mn), Euro-Yen (JPY 25bn), Canadian (USD 300mn equivalent), and Investment Grade 144A (USD 300mn) index-eligible securities not already in the three regional aggregate indices. The Global Aggregate Index family includes a wide range of standard and customized subindices by liquidity constraint, sector, quality, and maturity. A component of the Multiverse Index, the Global Aggregate Index was created in 1999, with index history backfilled to January 1, 1990. All indices are denominated in U.S. dollars.
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