MACRO
On the inflation front, we see overall more downward pressures. Over many months increases in rents had a significantly impact on the core inflation, given it’s over 40% weights in the index and steady increase of its contribution since mid 2021. With recent stabilization of the US housing and rental market, there should be smoothing impact on the core inflation estimate. Also prices of core goods (ex food and energy) as on downward trajectory (mostly thanks to declining prices of used cars and apparel).
The FED however, does not want to take the pedal of the break to prevent from inflation taking off again. It is due to cautionary tale of 1970’s, when during 8 years tenure of the FED chair Arthur Burns annualized inflation rate was 6.5%. Similar to many economists today, Burn’s thought that the inflation arose from a variety of special factors, each of which was largely out of the control of the Federal Reserve (such us poor harvests, restrictions on oil production). He was also under political pressures from Nixon administration to lower rates, prior to the presidential election in 1972. Many analysts think that today the FED is also under the political pressure of upcoming elections, which will deter FED from further hikes despite risks of inflation staying stubborn above 2% target. Research finds that historically, such pressures had an impact on the monetary policy (A. Dentler, 2019) .
On the growth front, global growth is slowing. The Global manufacturing and services PMIs declining, and for Europe already showing deteriorating business conditions. Most investors stayed bearish this year, and all of them have been wrong since the October last year. In fact at the start of 2023, for the first time in history, majority of published analysis where predicting decline in equities for the year. Their believe is that because monetary policy operates with long and variable lags, US economy is yet to feel the impact of the interest rate increases. And due to the post-pandemic, pent-up liquidity; recession will arrive much later than most analyst anticipate.
RATES
The FED by keeping rates high, want to restore the mechanism of price discovery, which has been suppressed by prolonged period of ultra-low interest rates. Since GFC, FED and other central banks have been the biggest buyers of the government debt, suppressing yields for over a decade. Now with a reduction of the FED’s balance sheet and increased issuance of treasuries, we have a drastic change in the supply and demand equation.
US Treasuries are experiencing the highest drawdown in history (in nominal terms, in real terms it was drawdown cause by the Great Inflation of 70’s). Furthermore the decline in value of treasuries is magnified by declining value of the dollar they are denominated in.
Source: Mac Faber
As the fiscal deficit swells and inflation remains elevated, bond investors looking for greater compensation and are pushing yields higher.
Significant investor demand for government securities is driven by the diversification benefit, this benefit however, depends significantly on the prevailing regime. During the periods of higher inflation, correlation between government bonds and equities turns positive losing their efficacy as a hedge and a tool helping to increase risk-adjusted returns. This is most visible during the inflation shocks, where both bonds and equities loose value, which we saw last year.
CREDIT
Since GFC, commercial banks have been under regulatory pressure which make them harder to lend to companies and individuals. Due to decrease lending activities, they where forced to increase their investments in treasuries in order to keep profitability for a price of duration risk. Recent regional banks crisis unveiled large duration mismatches at many banks, which would not be able to survive without the FEDs sopping QT and restoring the confidence.
Rates remained resilient, due to substantial decrease in supply, as many companies where able to get cheaper rates and refinanced in 2020 & 2021. Both of those years where the record issuance years, where companies where extending their issuance at a much lower level. Also for last two to three years, companies where operating at record profit margin, which gave them a bit more cash cushion and elevated cash on balance sheet relative to the historic levels.
Refinancing should not be an immediate issue, but low issuance since the start of the rate hikes aggregates refinancing needs into refinancing wall which is getting close. In 2024 only 2% of HY debt is going to be refinanced, but in 2025 this number goes to 12% and to 15% in 2026. Since companies usually start to refinance at least a year in advance, we should see big increase in the number of refinancing activity towards the end of 2024.
EQUITIES
Sentiment remains bearish (AAII survey), and positioning remains underweighted (according to BofA Global Fund Manager Survey). As investors still expect recession, there is little recovery this year in the mid caps and small caps and majority of equity gains, has been driven by the mega cap tech. As investors concentrate on technology, defensive stocks (Staples, Health Care, Utilities) have been the worst performers. Additional explanation is strong historical correlation between performance of defensive stocks and bonds, which experienced heavy losses this year.
Relative performance of Equities and Corporate Bonds (S&P 500 Index performance vs ICE BofA Corporate Total Return Index)
Source: Koyfin
The equity risk premium for the US market is lowest in 20 years (or since the US invaded Iraq). Premiums will improve if either rates will go lower or if the forecasted growth will improve. Equity analysts are ramping up their earning estimates. Expectations are that while margins may contract during a mild recession, nominal GDP and revenue growth will keep increasing at a reasonable rate.