MACRO
Investors observe generally weakening global economic backdrop. This is a reflection of the rapid tightening cycle, which continues despite the softening global growth. There are fiscal concerns around growing deficits and increasing debt servicing costs caused by the higher rates, as they may lead to the financial instability. Simultaneous quantitative tightening (QT) and increased issuance absorbs most of the available liquidity, and pushes funding costs higher which adds further pressure on economic growth. Nevertheless the resilience of the economy was so far, much stronger than anyone anticipated. Proponents of the soft landing or no landing scenario have been right through out this cycle.
On the global macro front, the main theme remains the wide-ranging geopolitical changes. Fracturing and defragmentation of the global supply chain is lead by the geopolitical divide, and its reflected in international trade, investment flows, changes to activities of economic clusters and financial market composition.
Those changes affect global investment landscape, and most servery China. Since the rapid shift to more socialistic stance back in 2021 (including reforms targeting industries such us: private education, gaming and technology) Chinese equity valuations have been more heavily discounted compare with US as well as world ex-US indexes.
RATES
US Treasury yield curve is going through major recalibration, as its reverting from the most invested point in decades. This shift is lead by bearish steepening where the longer term yields (10Y and 30Y) are raising faster, than the FED funds rates and short term rates, which recently became more stable. US 10-Year real yield broke 2% for the first time since GFC and 2Y-30Y has just flipped positive for the first time in this cycle (2 bps positive with 30Y yields of 5.09% and 2Y yields of 5.07% this Friday).
There are few explanations for recent rapid increase in longer term rates. On fundamental level, market participants adjusting their view of what is the long-term neutral rate. Key drivers of those expectations have been described in the Week 39 update. Other investors argue that interest rates shock has not fully made its way through the system, and have low confidence in the near term future of the US economy. They are requiring higher maturity premium, which also explains the bearish steepening. In addition from technical perspective there is very significant increase in supply of treasuries that pushes longer end of the curve up. At the same time the type of buyer has also changed, as we are moving from structural demand led by the FED to more price sensitive private demand.
CREDIT
As markets trying to digest one of the fastest tightening cycle in the history, we have not allowed effects to ripple through the economy. Although treasuries have been repriced, this haven’t flow through to the other markets, with credit haven’t been repriced to the extend many analysts expect.
Spreads picking up, but the adjustment is slow compare to dynamics of rates market, and tightening of the credit conditions. Partially this is caused by the lag effects. On the other hand in recent years there was a significant change to the structure of credit markets which makes historical spread levels less relevant. In addition the total return in credit is about 9%, which attracts more allocation to the asset class as investors are seeking to increase total returns. Prior to the GFC, HY investors where looking on total returns, it’s only post GFC in ultra-low rates environment is when the HY investor’s focus shifted to spreads.
Defaults also starts to pick up with more bankruptcy filings this year, than in any year since 2010. As earnings grew at fast pace some of the better managed companies managed to deleverage today. Earnings may not keep pace with the increase in the borrowing cost.
EQUITIES
In recent weeks, we have seen weekend in equities, and major US indexes are down to around their 200 DMA. Geopolitical situation also adds to volatility which has been contracting throughout this year.
The weakness int he equity market could be a good buying opportunity. This is due to positioning as most investors are underexpose to equities due to bearish outlook and will look for opportunities to add to exposure. Furthermore, as we approach end of October, markets enter more positive cyclical outlook, since November and December months are frequently associated with the equity market rally.
With FED beeing less prescriptive and more data dependent investors are struggling to discover a fair value.