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Waiting

  • 25 Agosto 2023 (7 min read)

Economic growth in most advanced economies is well below trend and inflation is falling - that should be enough to prevent further monetary tightening. However, there is no guarantee today’s soft landing will not evolve into an outright recession, even if current data doesn’t suggest that will be the case. Markets are not clear. There has been no recession-led cheapening of risk which continues to make cash and near-cash returns attractive to many. Until a more classic end-of-cycle correction happens, investors will struggle to find value in markets. If there is a downturn, the real returns will be made on the recovery. There’s a lot of firepower waiting for such an opportunity, but the wait might go on and on.

Soft but no shock

We are already in a soft landing. Downturns always go through a period of below-trend GDP growth. Most extend into an actual contraction in economic activity – a hard landing. US GDP growth is lacklustre and has been since the second quarter (Q2) of 2022. Eurozone growth is even softer. Looking back through history, it is the change in the growth rate which is as important as the actual growth rate itself. Recessions are typically associated with a big deceleration in the growth rate (the second derivative of GDP). When that happens – think of it as a growth shock – companies typically respond by laying off workers; the unemployment rate rises quickly and consumer spending falls. That typically leads to lower inflation.

Resilience

The recent debate about a soft landing versus a recession misses the point. What is important is whether the soft landing stays soft. We are not currently experiencing a growth shock. US GDP growth has averaged 1.6% over the past year against a long-term average of 2.5%. Based on Bloomberg’s consensus forecasts, the nadir of year-on-year GDP growth will be in Q2 next year. Then growth should be around 2% lower than a year earlier. That change in GDP growth would be consistent with a soft landing. Given businesses and consumers have the pandemic in their recent memory and that this has been the most forecast recession in history, they may not react as negatively as in more typical recessionary periods.

If unemployment does not rapidly rise, the Federal Reserve (Fed), and other central banks, will be reluctant to cut interest rates. This makes it more difficult for the market to price in rate cuts. Moreover, a soft-landing means rates will not fall by as much as in a recession. So, the average expected short-term interest rate is higher than it would otherwise be. That means long-term yields embed a higher term premium. Hence the rise in US Treasury and other global yields over the summer and the lack of confidence in long duration strategies. The sell-off in bond markets in the first three weeks of August has provided a better entry point but there might still be disappointment.

Not the 2010s

The decade following the global financial crisis saw real GDP growth oscillate in a narrow range against that 2.5% long-term annual average. In the aftermath there were no real US growth shocks (Europe had its existential euro crisis of course) so firms were able to comfortably manage the ups and downs of the business cycle. Unemployment fell from almost 10% in 2010 to 3.6% in 2019. Inflation was low and relatively stable during that period, tending to undershoot the Fed’s target range a lot of the time. This led to rates being cut to exceptionally low levels and to quantitative easing. A return to that kind of environment would be very supportive for financial assets. But it is extremely unlikely. Inflation being more symmetrical around central bank target levels makes for higher policy rates (on average) and probably more frequent policy adjustments.

The debate continues

Market behaviour so far in 2023 has been consistent with a soft-landing scenario. Equities have outperformed bonds and bond yields have recently moved to levels consistent with a medium-term equilibrium interest rate that is above what prevailed during the 2010-2020 period. But inflation is still higher than it has been since the early 1980s. All recent periods which have witnessed a sharp decline in inflation have also been when there has been a recession and a significant rise in unemployment. This is the economic scenario most investors seem to still expect. The fact that it has not emerged is perhaps a matter of timing rather than getting the fundamentals view wrong.

Data and potential shocks

The odds have been against a soft landing. They rarely happen (without a recession following) and in this cycle rates have increased aggressively. So far, the data has come with an easy landing. There may just be early signs of some cracks though. Purchasing Managers’ Index (PMI) surveys have been very feeble, and the most recent batch not only highlighted a manufacturing sector already in recession but that the weakness was also spreading to the much bigger services sector. US corporate results point to consumers shifting down their spending to lower-price retailers. It may take a financial shock to provoke more cautious corporate and consumer behaviour - and there have been some red warning signs. Ongoing problems in China’s property sector suggest a debt deflation problem in the world’s second-biggest economy; the narrative around Germany is one of weak growth, and focused on a lack of productive investment over the last decade; Argentina could potentially elect a president that makes some interesting - and market shocking - policy decisions; and Russia’s partial isolation from the world economy is both impacting the Russian economy and threatening global commodity prices as we head towards winter.

Any bargains?

Investors are focused on the complexity of US growth, inflation, and the impact of policy. Black swan events are always in mind. The totality of that means cash continues to be attractive. I went through the mental exercise of putting myself in the shoes of a wealth manager, with 20%-25% current cash holdings – earning close to 5.5% in US dollars, and 3.75%-4.0% in euros. Would I suggest it was time the model portfolio started spending that cash on riskier assets? The honest answer is no, not yet. There is not much that is clearly good value. Potentially, long gilts? High-yield fixed income is not particularly cheap but has an attractive yield with much of the total return coming from income. Investment grade credit is attractive, but spreads are not that wide and it is only because risk-free rates are higher that the asset class looks worth investing in with a medium-term view in mind. Equities are not cheap and really require a long-term view. Given existing allocations, it is a hard call to add to stocks at this stage. Long-term views, of course, lend themselves to equities but they need to be able to beat a 4% to 5% risk-free return for the next couple of years.

Hard but opportunistic 

It would be better if there was a market cheapening. For so long I seem to have been saying that cash returns will peak. The ideal market strategy for many would be that a hard landing follows a soft one, rates are cut more quickly than currently priced in, and equity and credit assets cheapen considerably. In other words, a typical end-of-cycle outcome. Yet if that is what is desired, and what is expected it probably won’t happen. It might only happen if there is a shock. Markets are full of people regularly insisting that some event or other constitutes a shock, but those things rarely do. It is the so-called unknown unknowns that really create the value opportunity.

A few people make money by anticipating a market downturn, not many though; see The Big Short, which neatly illustrates this. After a downturn, most investors make money in the recovery. If there is no big downturn and no big subsequent recovery, then it is about income and staying in quality assets – particularly in the absence of glaringly cheap assets. A credit fund that invests in bonds with a maturity of one to three years with a yield of between 6.5%-7.0% in sterling, 4.0%-4.5% in euro and around 6% in US dollars fits the ongoing soft-landing scenario. A buy-on-dip approach to equities might not be a bad complement to that from a tactical point of view. The US’s Q2 earnings season was better than expected and the next quarter will see the year-on-year comparisons get better. Nvidia’s Q2 earnings reports support the view the artificial intelligence theme can continue to deliver returns even if the cyclical picture weakens.

Will the 2021 inflation shock just fade away? 

A soft landing is only possible if the process of returning inflation to target levels is driven by the original price shock fading away. If inflation has more legs than that – wage and price growth is high even when the original shock fades – then monetary policy will need to be tighter for longer. In such a scenario, it is difficult to avoid the hard landing. I’m not sure markets have decided how it plays out from here. There is limited monetary easing priced in and bond yields have risen over the summer. Yet inflation has fallen a long way, and in the US, headline consumer price inflation is expected to be below 3% - with core below 4% - by the turn of the year. Together with the weakness in the PMIs there might be enough to support the disinflation thesis which is positive for fixed income; and bonds are getting very cheap again.

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

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