Macro
The FED has a chair with a very dovish message, and the committee members are walking it back. But even with J. Powell’s dovish tone, markets have been already well ahead of the FED. Bonds have rallied, and financial conditions have eased, which could create more inflationary pressure. The concern is that the market is starting to price in rate cuts earlier and earlier, and the more the market thinks the FED is over, the more easing there is of financial counterbalancing tightening efforts. The FED needs to start moving the rates down, but they can do it slower than the market expects and over a more extended period, as the strong economy does not require any fast adjustment.
The FED’s new projections for GDP are 1.5% with a Core PCE of 2.5%, reflecting full normalization of the macroeconomic conditions. Since the FED focuses on the ‘real’ (rather than ‘nominal’) interest rate, they have to reduce the nominal rate to keep the same rate of restrictiveness. With the historical real interest rate between 0 and 100 bps and the expected reduction of inflation by Q1 2024, the FED would need to reduce the nominal FED funds rate by as much as 200 bps.
Alongside subsiding inflation, we see more balance in the labour force. Unemployment started to rise, and average hourly earnings growth began to slow. This softening labour market is good news for both the FED and the market. It takes away the pressure from those who want to hike further and brings more optimism to those afraid of further hikes. This dynamic strengthens the soft landing opportunity, creating the Goldilocks’ sweet spot.
Rates
We just went through the most extraordinary drawdown in the bond markets in decades. For three years, bonds were losing money for the Fixed-income investors, so some long-term bonds were trading below 50 cents on a dollar. This move was caused by a rapid tightening cycle and repricing of the yield curve highlighted on the graph below.
With so many losses built up in the Fixed-Income space over the last three years, the future total returns look extremely attractive.
Since the end of October, rates have reversed, predicting the end of the hiking cycle. Short-sellers aggressively unwind their positions, and many investors piled on duration exposure. Consensus believes that the interest rate tightening cycle is at an end. After last week’s J, Powell’s surprisingly dovish tone has caused the 10Y yield to nose-dive below 4%.
Credit
Extending on the rates picture presented above, investors need to look at the total returns component. Some of the highest quality European IG Corporate bonds were financed at negative rates during Covid; now, with few years left to maturity, they are quoted at over 6% yields. Also, the agency mortgage-backed AAA assets are currently paying over 6%. This creates a wonderful setup for the total return. For managers with skilful bond selection, it will be possible to generate double-digit returns in high-quality assets if interest rates decline.
Investors, however, point out spreads, which are very tight given that, till recently, we had predominantly recessionary expectations. The argument for low spreads is that total yields remain attractive, especially given market expectations of multiple rate cuts next year. Also, relative valuation looks attractive with rallying public equities, recovering private equity valuations and a large amount of dry powder in private equity and private credit. An additional argument is a relative supply-demand imbalance, with a much lower issuance volume throughout 2023. Let’s start seeing issuance volume pick up with the recent drop in yields and tight credit spreads. Although the considerable risk to the downside is that soft lending consensus won’t materialize, it is difficult to ignore the high carry.
With all those tailwinds, credit investors should remember that the lowest credit quality issuers are the most negatively affected during the credit tightening cycle. Now, we have the most significant skew to the lowest credit quality issuers on record, with over 80% of value in BBB and below-rated issues.
Equities
For most of the year, the market has been driven by the mega-cap tech, but since the FED’s updated dot-plot chart, the rest of the market joined the rally. Valuations in most market areas are still attractive, with the heavily discounted energy sector returning over 10% free cash flow yield.
As reported by Factset, equity returns were positive for most of the year, and even tails were skewed toward positive (upside surprises). The most significant moves were attributed to the performance of mega-cap tech stocks, a bounce after the banking turbulence, and a few instances where the macro developments turned positive for the FED.
It is worth flagging again that the top 10 best-performing stocks accounted for 75% of the S&P 500’s return, well above the 39% average over the last decade. This return concentration amongst the largest tech stocks cannot last forever, and with a moderating macro outlook, we should see a broadening of the equity market rally.