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How to position as we approach late cycle

Apr 08, 2022

Cross Asset Strategy 

The first trading week of Q2 saw renewed concerns over growth, policy tightening and geopolitics. Depending on which day of the week you were looking at, the U.S. Treasury yield curve was either inverting more, or spiking up across the curve. This is sparking conversations about ‘late cycle’ and the inevitability of a recession. Fed speakers continue to lean more on the hawkish side. Lael Brainard sparked a tech sell-off by urging balance sheet reduction ‘at a rapid pace’. For investors who thought a Fed funds rate of 2.6% at the end of 2022 and 3.2% at the end of 2023 was already punishingly high – quantitative tightening will bring even more angst. While we continue to think a ‘soft landing’ is the most likely scenario, we can no longer rule out a hard-landing as a possible outcome. Geopolitical uncertainty also remains high, as no one knows how the Russia/Ukraine conflict will evolve. Asian markets are not immune to these external headwinds – and China is also faced with another COVID wave. That said, there are still selective markets to like in Asia, such as Hong Kong – where value is starting to emerge, China onshore – given the policy tailwind, South Korea – where the DRAM memory cycle is bottoming, and finally Indonesia – which continues to be the region’s favored commodity play.

Strategy question: How to position as we approach late cycle

As we discussed in the Asia Strategy Weekly two weeks ago, we see mounting headwinds to growth in the developed world and have revised down our GDP expectations. Today we follow up with a deeper dive on the implications across asset classes.   

We are on a quick path to late cycle. Over the past month, all U.S. Treasury yields rose led, by a historic 1% increase in 2-year yields. The 2s10s yield curve is now inverted, signaling continued, rapid progress through the business cycle. Since 1975, this is the fastest our business cycle index has moved from recession to today’s level of ~55 (60 marks late cycle). We expect to hit the late-cycle threshold in the back half of 2022.

On the Fed – our key takeaway from the March FOMC meeting was to expect more tightening, and post-FOMC every Fed speaker has reinforced that message. The market-implied probability of a 50bps rate hike at the May FOMC meeting is 95%; conditional on a 50bps rate hike in May. There is also a 90% probability of another 50bps hike in June. We now expect the Fed funds rate to end the year at 2.25%, about 75bps higher than we did previously. 

So why the urgency?

  1. The U.S. labor market is red hot. The Fed characterized the labor market as “extremely tight” and “unhealthy”. These are emergency words. “Extreme” was last used at the onset of COVID and before that in the wake of the GFC. “Unhealthy” was last used in March of 2008. With the labor market so tight, inflation is now mostly demand-led. Goods inflation is no longer relevant for Fed policy; even if/when goods based inflation cools, it won’t be enough to bring inflation back to mandate.
  2. Inflation-fighting credibility is at risk. We still consider inflation expectations anchored, but inflation is behavioral and the longer inflation stays high, the more likely those expectations become unanchored. Does Chair Powell want to be remembered for reversing decades of inflation-fighting credibility? Probably not, and hence he is inclined to tighten more than economists expect.  

This outlook has led us to two key investment implications:

Firstly, the overall risk/reward profile of core fixed income solutions is improving. We think elevated inflation could still possibly drive the short-end yields higher from here, and this part of the market will likely remain volatile. For long-end yields, given the fact that the 10-year is now near the top quarter of our 0.75%-3.00% long-term range, and near estimates of the neutral policy rate, the levels will likely be anchored against further sharp moves to the upside. Our outlook for the 10-year U.S. Treasury yield is now revised to 2.50% (+/- 25bps) by year-end 2022.

The increase in core fixed income yields has narrowed the relative value gap between core bonds and riskier assets. Core bonds also provide diversification benefits as we move through the business cycle, and as downside protection in a late cycle/recession scenario. Adding core fixed income with yields above 10-year medians now looks more compelling than before. Investment Grade yields have risen +4%, with the spreads around 10-year medians and Treasuries well within our 1-year forecast, which compels adding exposure at the 5 to 7-year points of the curve. We are looking for continued volatility or spread widening opportunities to add to solutions down the capital structures (such as preferreds), rising stars in High Yield as well as corporate hybrids.

Secondly, return expectations for equities are softening. In the short-term, we continue to expect the S&P 500 to trade range-bound within the recent 4,200–4,600 levels. While our 2022 earnings-per-share (EPS) growth estimates for U.S. equities are still above the long-term average annual rate (+10-12% expected), we expect 2023 EPS to be slightly below average (+4-5% expected). We slightly lowered both our expected year-end multiple (to 18.5x - 19.2x) and our earnings estimates to account for an increasingly aggressive Fed and progressively slower growth outlook. Downside risks to intermediate-term earnings estimates are higher when the Fed is trying to engineer a slowdown in growth and inflation. In our base case, we expect the market to pay close to 5-year average valuations at ~19x 2023 earnings; which represents mid-single digit upside from here (or roughly similar to other, less risky asset classes). Our 2022 outlook for the S&P 500 is revised down to a range of 4,600–4,700.

In terms of sector positioning, we would suggest a balanced approach across reasonably-priced-growth, cyclicals with a secular growth catalyst, and defensive growth. We have a positive view on Healthcare and reasonably-priced Technology. Given the ongoing headwinds, we think it’s prudent to take profits on sectors like Consumer Discretionary, which will likely be hurt by elevated inflation, as well as to sell cyclicals, such as Financials, on rallies.

All market and economic data as of April 7, 2022 and sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.

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