Macro
Macro data remains inconsistent, with US remaining strong but global growth generally rolling over. Outside of US focus remains on the Chinese economy, with worrying decline in the households wealth (about 70% of which is linked to distressed property sector) and their rapidly falling propensity to consume. Government is pushing local authorities to increase infrastructure projects and sponsor them through bond issuance.
For the US economy, concerns are mostly related to the fiscal deficit and costs of borrowing. The increased treasury supply, and declining global treasury demand adding additional pressures.
Rates
Yield Curve has been inverted significantly and for a very long time. More specifically when measuring inversion using:
- Treasury yields on 10-Year and 2-Year, since July 2022,
- Treasury yields on 10-Year and 3-Months (which is more frequently used measure of inversion by the FED), since October 2022.
As we see the above yield differential chart, I have plotted since 1980’s, the inversion of the yield curve is an infrequent, short-term occurrence. This is strongly supported by the financial theory, which suggest that investors should demand the term-premium to commit to investment for longer. Therefore it is a matter of time, until the yield curve will steepen back to ‘normal’ shape. The question investors are asking however, is if this return to normal will be lead by increase in the longer term rates, or a decline in a shorter term rates. First scenario supports higher for longer view with a positive economic outlook. Second scenario focuses on recessionary expectation which will force FEDs hand to cut rates in order to stimulate the economy.
The yield curve is already normalizing since middle of the year. Yield gap is closing by bear steepener, meaning the long-term rates are raising faster than a short-term rates. This is supported by the continuous positive economic data and continuous hawkish stance of the FED.
Credit
Despite slowing down economy and cuts in the growth forecast, credit market remains highly liquid. We may see some dips in the liquidity towards the end of the year, but there is plenty of available cash from investors, and there is consistent appetite for the primary credit products. Some of this liquidity is subject to market conditions and investors risk appetite, both of which can quickly change if the economic outlook worsens.
Equities
Positioning remains defensive, however this year lower equity exposure has significantly lower expected impact on the performance. This is due to a high short-term rates, which reduces impact of the cash drag in defensive portfolios. Additional liquidity for defensive purposes gives investors a more comfortable way of navigating through complex macro picture, and allow them to prepare for additional volatility in case the expected soft landing won’t materialize.
Given a generally positive outlook reflected in equity valuation, there is a prudence in maintaining extra liquidity to soften impact of the undervalued tail risks.