Macro
U.S. economy has proven to be consistently resilient in the face of many headwinds. US is a $25t economy, in 77% represented by services, and 68% represented by consumer which remains resilient. Question is how long would it last given shrinking savings.
Source: FT
Consumer demand is also continued to be supported by demand for workers and healthy labour market. Job growth given comsumers confidence to excesively spend. However concern is that the higher debt servicing costs for business and surging household borrowing costs, will put a break on demand as soon as the excess savings are depleted. So far, rates increases had mostly impacted the property market (especially commercial real estate), with housing afordability index being lowest on record. They lead to a lock-in effect by restricting housing supply due to increasingly negative mortgage rate differencial between new homes and currently owned properties. This will restrain broader econmy over time.
Most investors this year where bearish and forecasted recession. Many of them forgot that the FED is fighting the inflation not the business cycle. So far investors in the soft landing camp where correct.
Rates
It is unlikely that the FED will consider rate cuts until they gain confidence in the view that inflation will decline to 2% target. FED did a very good job of trying to get ahead of the market and talk hawkish and trying to convince the market that rates will stay higher for longer. It is a good communication strategy, as its much less risky to cool off the expectations of easing than trying to play a tightening catch up. Especially if risk to inflation has been historically to the upside. Furthermore during the periods of accelerating prices inflation tend to spike few times, before stabilizing.
Given the recent rapid increase in 10Y treasuries, market has took this message on board. Over the 10 years market is now estimating the FED funds rate to be 4.5%. The average spread over multiple cycles, between the FED funds rates and the 10Y is about 100 bps, therefore if those future funds rate expectations are correct, then 10Y could go over 5%.
Interesting point is that nominal amount of interest paid by US IG & GY companies has increased at faster pace in last 1.5 years, however over the same period, the total nominal amount of interest received by S&P companies on their short-term cash balances has multiplied.
Credit
Bankruptcies have been increasing, but high yield spreads remains low and credit investors are criticized for complacency in face of increased credit risks. There are few explanations to why HY credit spreads remain resilient and lower then many investors would expect given the macro backdrop:
- Prior to 2020, companies in HY universe where providing 20% of security,
- Now this is 60% of security. Furthermore their average maturity has declined.
- And what you price on HY is default compensation but also the recovery potential. There is higher recovery potential with more security, and less default compensation for the shorter maturity.
- Credit market has roughly half the amount of CCC rated debt, compare to level before the GFC.
Credit conditions are still tightening and macro environment is not very supportive, and expect to worsen, which exposes credit securities to sharper drawdown. The most exposed area of credit market is the leverage loans market. They have the weakest fundamental position, and are exposed to the borrowing costs increases the most since 2022. Higher for longer means that companies who where trying to wait-this-out, wont’ be able to wait-it-out forever. Therefore it will be very difficutl for new supply of the corporate bonds to time the better entry point. Will all potential risks on the horizon, its worth to remember cautionary wall-street adivse – “Never hire an optimistic credit manager”.
Equities
Looking at the action across the emerging markets, we see risk on sentiment from equity investors. Market now believes that rates has peaked and the next step of the FED is the rate cut, which gives a green light to the year-end rally. This also has lead to broad-based participation of individual stocks in the rally. This is also supported by positive near-term market outlook and increased appetite for equities of investment managers according to S&P Global IMI survey. This comes at the time when State Street indicator shows that October’s positioning of the institutional investors was most risk-averse since May. Last time the mood has shifted so significantly was in October 2022. Many mangers will behave similar fashion and those who missed this rally will try to avoid repeating the same mistake.
Expectations of lower rates should also give some boost to the REITS, which have been severely affected by increase in rates over last 1.5 years. In fact REITS total market cap as a portion of S&P 500 has been declining since the bursting of the US housing bubble in 2006, and the subprime mortgage crisis leading to the Great Financial Crisis (GFC) of 2008-2009. Prior to GFC at 2006 peak REITS constituted over 14% of S&P 500, now they represent less than 5% of the total market cap.