Soft landing or hard landing?

Author: Global Investment Strategy Team

Cross Asset Strategy

Hawkish remarks from Chair Powell sent risk assets lower and yields higher this week. At his Senate testimony on Capitol Hill on Wednesday, Powell doubled down on the Fed’s commitment to cooling inflation, signaling that policymakers could take policy rates higher and ramp up the pace of hikes if necessary. Rates markets quickly reacted to the remarks, re-pricing the probability of a 50bps move at the March FOMC meeting to 70%, as well as a terminal rate at 5.6% (10bps higher). As a result, 2-year yields surged +13bps and topped 5% for the first time since 2007, pushing the 2y10y over 100bps inverted – a first since 1981. The dollar climbed over 1%, and long-duration assets (i.e. growth equities) dipped.

The January data was strong across the board – and while we think the overall economy is still on a cyclical slowdown, and January’s strength may still be attributed to seasonal adjustments and warmer weather, the risk is that sticky inflation and higher rates could be around a bit longer than we previously thought. February data is the key to watch from here in order to assess whether the softening trends that we had seen in Q4 are truly reversed. That said, we are still feeling comfortable about our macro base case. Read on for a deeper dive on how we think of the U.S. economy and investment positioning…

Strategy Question: Soft landing or hard landing?

Over the past month the U.S. economy has proven more resilient than expected, driving rates higher across the curve. 10-year Treasury rates are again testing 4% and the average U.S. 30-year fixed rate mortgage jumped ~60bps to nearly 7% (setting up a challenging start to the 2023 home buying season). Despite the shift higher in yields, the S&P 500 is down only 2% (which is underperforming Europe in local currency and U.S. dollar terms). The U.S. equity risk premium, which compares the expected yield in stocks to bonds, declined notably, suggesting bonds are even more attractive relative to equities than they were last month.

Our business cycle indicator continues to scream late cycle, but it is less late cycle than last month. A slowdown in corporate investment and a decline in residential capital investment drove the indicator lower, consistent with tight financial conditions changing behaviors towards lower growth outcomes. Historically, these are the variables that lead the indicator lower heading into a recession.

After 5 months of slowing payroll growth, the U.S. added 517k jobs in January. Similarly, after two months of declining retail sales, consumer spending surged in January. One month of data prompted the notion of a “no landing”, reflecting a view that growth could remain at or above trend (think ~2% real GDP growth) for an extended period, despite the historic tightening in financial conditions we have seen over the last 12 months. We disagree and continue to see rates as restrictive leading to eventual slowdown:

1. Housing is in a recession and it’s likely to prompt construction layoffs, joining previously announced tech and financial job losses. Completed residential home projects now outpace new home starts and there is no longer a backlog of uncompleted COVID-era homes.
2. Bank lending standards have tightened dramatically and may portend a continued contraction in corporate capital investment.
3. Auto and credit card delinquencies are starting to rise, albeit from low levels.

With restrictive rates, the U.S. recession roadmap presses on. So how is it tracking?  Step 1: financial conditions tighten – done in 2022. Step 2: interest rate sensitive sectors deteriorate – done. Step 3: corporate profits deteriorate – we are here. Q4 2022 earnings season is nearly over, and it appears that S&P 500 average earnings growth will likely be negative year-over-year (YoY), led by mega cap names. We expect negative growth in Q1 2023 as well, leading to a technical earnings recession. Step 4: defend profits, via layoffs. Job loss is historically a non-linear process, and it happens fast; the acceleration in job loss defines the “recession”. We still expect to be here in Q3 2023, but the probability of that slipping to Q4 2023 has grown. Step 5: defaults rise / inflation slows to mandate.

This is what late cycle feels like. For some, the rich valuations in equities and credit spreads seem overdone. S&P 500 valuations are still rich to any historical average we care about, and USD investment-grade (IG) and high-yield (HY) credit spreads are in the ~35th percentile relative to spreads witnessed over the last 13 years; while the EUR spreads are more average. We normalized S&P 500 and U.S. IG valuations across prior business cycles using our business cycle index – and since the 1970s, on average, stock and IG bond valuations start attractive in early cycle and by late cycle are expensive. If we consider today as a continuation of the previous cycle (2009-2019), then equity multiples and IG spreads are about as expensive as history would have predicted. History suggests late cycle investors tend to favor core duration and high profitability stocks over low profitability.

With rates approaching overshoot territory again, consider adding duration. The recent rise in yields across the curve has been driven by a shift in the market’s outlook for 1) a higher expected terminal fed funds rate – 5.4% today vs. 4.85% last month and 2) a later expected timing of rate cuts – Q1 2024 today vs. Q4 2023 last month. The resilience of the labor market and spending data, as well as stubbornly high inflation, drove the repricing in rates. January PCE data shows inflation is proving to be sticky at ~4.5%, shrinking the probability of the immaculate disinflation scenario. But to take it a step further, even if the Fed thinks rates are high enough to cause a material slowdown in growth (like we do), additional rate hikes will likely prevent financial conditions from easing prematurely. Like any great CEO, the Fed is ‘risk managing’ their business; the risk of hiking too little still outweighs the risk of hiking too much.

In light of these, we revise higher our expected Fed rate path and our year-end 2023 10-year U.S. Treasury outlook. We expect the Fed to keep hiking rates by 25bps until payroll growth slows materially (<100k monthly payroll gains); we expect that criteria to be met as we approach mid-year. We continue to think rate cuts commence in Q4 2023, but admittedly the probability of cuts happening in early 2024 is nearly as likely. With a higher expected policy path, we see 10-year U.S. Treasury rates declining to 2.85% at YE 2023 (vs. 2.5% prior).

For investors, the key pillars of our conviction on duration remain, and the merits have strengthened:

1. Yield – Consider locking in elevated yields while you can and reduce reinvestment risk. Rates are restrictive and likely to decline in the future.
2. Protection – A recession is most likely what causes rates to decline.
3. Capital appreciation potential – 91% of the JP Morgan IG index trades below par, with the average bond trading at 90 cents. If rates rally, bond prices could rise, and may push total returns higher than current yields.

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Index definitions

Standard and Poor’s 500 Index is a capitalization-weighted index of 500 stocks. The index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. The index was developed with a base level of 10 for the 1941–43 base period.

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