Investment Institute
Viewpoint CIO

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  • 21 July 2023 (3 min read)

Markets have positive momentum. The bear arguments are well rehearsed, but the evidence of either re-accelerating inflation, or an economic hard landing is not clear. Mind you, it’s easier to be “not invested” when earning 3% to 6% in cash than it was when cash returns were zero. The bears could still be right but markets are creeping higher. For some risky assets, the 2021 highs are not too far away. For now, the trend is your friend.

Summer lovin’

 Markets have been on a bull run of late. Changing perceptions of the macroeconomic outlook have driven strong returns. At the time of writing, global equities, as measured by the MSCI World Index, are up 2.6% in total return terms in July. Total returns since the end of March have been 11%, and year-to-date, 18.3%. The consensus outlook derived from market developments has shifted towards a ‘soft landing’ for the US and other major economies. Inflation is falling and this has encouraged bond markets to reduce their expectations of peak interest rates and, more importantly, to revise down pricing of where official policy rates will be in 2024. Market pricing for where the US Federal Funds Rate will be by June 2024 are currently 30 basis points (bp) below their recent peak. For the UK, it is even more dramatic with pricing of the Bank of England’s bank rate for end-June 2024 now 78bp below the level it was at earlier this month.

Soft or hard?

The current monetary tightening cycle is almost over, and recent market moves are based on an expected higher probability of an easing cycle starting in early 2024. Both bonds and equities have benefitted. The extent to which they can continue depends on how the economic cycle unfolds from here. There are mixed views on whether there will be a hard, soft or no landing. But these terms are loosely defined. To me a hard landing would be represented by an officially declared recession. In the US, the National Bureau of Economic Research is responsible for dating recessions and expansions. In a recession, GDP declines. These declines can be modest – for example the 2001 recession – or significant – such as in 1981 or 2008-2009. They also see increases in unemployment. In all the dated recessions since the 1970s, the unemployment rate has risen by at least 2% and more often by much more.

Hard more often

If recessions represent the hard landing, the soft variant is when GDP growth slows sufficiently to allow enough slack to emerge to bring down inflation. This would mean below trend but still positive GDP growth, a modest increase in unemployment (around 1%) and a decline in inflation. That sounds relatively agreeable. It is hard to find a period where inflation has been high and comes back down to a more manageable level without there being a hard landing. There have been extended periods when growth has, at times, been positive but below trend and inflation has been well behaved. But this has tended to be in periods when inflation has been well behaved, not when there has been an inflation shock.

On trend?

This time could be different. Since the end of 2020, quarterly GDP growth in the US has been below trend around 50% of the time. On average growth has been at an annualised rate of 2.6%, very close to the long-term realised average. Immediately prior to the pandemic, the unemployment rate was 3.6%, the same as it was in June 2023. This is low by historical standards but there has been a structural decline in the unemployment rate since the global financial crisis – something also seen in Europe since the early 2010s and in the UK. You could argue the US economy is in a similar position to where it was in 2019 – at full employment but not with a massive negative output gap.

Hit by shocks

Of course there has been a huge shock since then. The pandemic first hit output and then hit prices. The bullish investment case is the inflation shock of the last two years was mostly a supply side one, and one where it created some modest second round effects. A period of below trend economic growth, engineered by a rise in real interest rates, should be enough to snuff out those residual inflationary pressures. Markets have gravitated to this view in recent weeks.

Round 1 knock-out or a slugfest?

This might be a fantasy and it is always dangerous to suggest this time is different. Inflation has come down a lot but getting it back to 2% could require more of a cost in terms of creating spare capacity (lost output) in the economy. We just don’t know at this stage. Investors are looking at the phase of the cycle right in front of us – falling inflation and interest rates eventually being cut. Central banks hit inflation hard and then, problem solved. But there are other scenarios. Anticipating a scenario of recurring inflation and more active monetary policy over the medium term is not easy. If the economy is at full capacity, the risk is that monetary easing in 2024 boosts growth and raises inflationary concerns again. This would ultimately limit the extent to which rates can fall and keep more of a risk premium in interest rate curves. Consistently positive equity returns would be difficult to attain in such an environment. By contrast, a classic hard landing would take the economy well below full employment, bring inflation down to very low levels and allow rates to be cut meaningfully and to stay low to promote recovery.  

It’s all in front of us

There is no doubt that the US economy has been stronger than expected earlier this year, and recently reported bank earnings for the second quarter support that. If there is going to be a hard landing, it hasn’t shown up yet. Typically, unemployment rates bottom just before a recession starts and it should be noted that the unemployment rate was 3.4% in January. It has moved a little higher and this may be consistent with previous cycles. We need to be patient to see what kind of landing we get. But the risk to continued positive market returns is that a hard landing does become more visible, and that is going to make investors reassess equities and high yield even though return indices remain below the highs they delivered in the second half of 2021.

For now, bonds love falling inflation. However, cash rates are high and are likely to remain high for most of this year. One-year US Treasury bills yield 5.3%, French one-year bills yield 3.68% and one-year deposits in sterling are over 6.0%. Implicit in lower forward cash rates is the idea that if you invest in short duration today – overnight money, one month or three-month assets, at some point you will be rolling over those investments at lower yields. In other words, returns from cash have been rising but they are peaking now. Eventually they will look less attractive.

Cash won’t beat forever 

Is that enough to force investors to go into long duration assets, or take on high yield credit risk or capitulate into the equity market rally? Bond returns have been below their long-term average since early 2022. The levels of fixed income total return indices are anywhere between 10% and 30% below that indicated by long-term trends. That indicates some significant upside still. It is also consistent with low cash prices in the bond market. For example, the average price of the Euro Corporate Bond Index (ICE Bank of America) is 90.41. It was 103.4 at the end of 2021. Markets and economists think the long-term equilibrium rate is well below today’s set of central bank policy rates and a gradual move towards those long-term equilibrium rates will mean lower yields across the curve and returns that are likely to beat cash.

US equities most vulnerable to hard landing 

For equities the debate about hard or soft landing is key. If lower corporate earnings result from a 2024 recession, the US equity market looks expensive. The S&P 500 is currently trading at 19 times 2024 forecast earnings. A 5% drop in forecast earnings pushes the multiple to 20 times. On an earnings yield equivalent that makes stocks look very pricey relative to a corporate bond yield of 5.5%. Multiples on equity markets in the rest of the world are much lower and compare, in the case of Europe at least, with bond yields that are also lower (8.3% 2024 earnings yield for the Euro Stoxx Index compared to a 4.2% yield on the Euro Corporate Bond Index).

The most conservative investment strategy remains cash and short duration assets. Cash returns will remain high in the short term but will move quickly lower in a hard landing scenario, while risk asset returns should outperform in a soft-landing scenario where profit downgrades and high yield defaults are limited. It’s hard to be overly bearish on any asset class but this could change as the data unfolds. In cash or in bonds and maybe in equities, returns are likely to go back to being positive in real terms as the 2022-2023 inflation hump fades away. Those 2021 highs in equity and high yield return indices are not that far away.

Performance data/data sources: Refinitiv Datastream, Bloomberg). Past performance should not be seen as a guide to future returns.

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