Every recession over the past 70 years or so has followed a sustained US Treasury yield curve inversion, although there is typically a lag between inversion and recession of approximately one to two years.
To combat persistently high inflation, the US Federal Reserve began to hike rates aggressively in March 2022. The latest 25 basis point increase contributing to a total tightening of 450 basis points in just 10 months.
An inflationary slowdown is the goal, a central bank-induced recession if you may, with a ‘soft landing’ the goldilocks scenario. And, of course, an inverted yield curve does not always foretell recession.
Indeed, we are sympathetic to the argument ‘this time it really is different’ owing to the unique inflationary circumstances induced by the Covid pandemic.
Inflation is good for the top line and, as such, nominal GDP has not collapsed. Corporate results have been resilient in the face of the fastest tightening cycle in more than four decades.
The credibility of central bank action has suppressed inflation panic and long-term inflation survey data has never broken above the 3% level. Furthermore, several months of supportive US CPI readings surprising to the downside are now boosting the peak inflation narrative.
Who can blame investors, battered and bloodied from the carnage of 2022, for pouncing on these bright spots and believing the rally.
Too good to be true?
The macroeconomic outlook remains problematic. Despite growing expectations of a pause in the hiking cycle, central banks’ resolve to fight inflation at all costs looks undimmed. That will weigh on growth and opposing central banks typically does not end well for investors.
Additionally, central banks are also embarking on a diet of quantitative tightening as they look to shrink their balance sheet belts after too many years of loose monetary policy.
Recent commentary from Bank of England governor Andrew Bailey, European Central Bank president Christine Lagarde and Federal Reserve chair Jerome Powell, each optimistic that the corner has been turned on inflation, has boosted sentiment. But it’s goods deflation that is causing the fall.
The more persistent pressure of wages, which in turn feeds through to stickier services inflation, remains heightened. Very few called inflation correctly on the way up. How it recedes may be equally uncertain. The central bank trajectory remains unclear and will be sensitive to incoming data.
Unfortunately, central banks are attempting to control inflation with a monetary policy tool that can’t address its root causes. It is a blunt instrument with a time-delayed impact in the real economy, so we expect restrictive real policy rates to hamper economic activity in the next few quarters.
Volatility should also be expected, as the impact of a fast-tightening cycle becomes clearer. In the corporate space, growth hits normally follow rate rises and multiples tend to trough before earnings bottoms.
Sector dispersion is significant, but many are yet to price in higher real yields and consensus expectations are not forecasting meaningful declines in margins from elevated levels.
From the consumer side, domestic savings have provided a buffer but these are steadily decreasing and spend on credit increasing as the cost-of-living crisis bites.
The tightness of labour markets is oft quoted as a reason why recession will be skirted, but it may just be postponing or masking recession risks, not eliminating them.
The mismatch between labour demand and supply is concentrated in a few sectors rather than being broad-based, whilst concurrent trends, such as a slowing in hours worked, suggest weakness to come.
End of the 40-year bull market
During past periods of uncertainty, risk markets have been helped by the 40-year bond bull market. That is over.
We believe we have entered a new era where asset allocation decisions will be influenced not only by how quickly we enter and exit recession but by what additional risk premia is needed in a world of structurally higher and perhaps less predictable ‘risk-free’ assets.
One thing is clear – government bond yields have reset higher and higher yields reflect more risk across all markets. Risky assets have not, however, re-rated to the same extent as risk-free: equity yields have risen to pre-covid levels but the excess yield from equities over bonds has reduced and reversed, altering the relative preferences of investors.
Credit spreads had widened but recent retracement has effectively priced out a recession and default cycle. Despite this, all-in yields are more important than the constituent parts and more attractive than they have been for many years.
Momentum suggests more money to flow into fixed income markets and limited supply in the face of strong demand means the technical is on the investor’s side (even if the easy money has already been made).
Our perception of the risks means a meaningful allocation to more defensive fixed income assets is warranted but if inflation were to ebb away and rates stabilise (or even fall) without a deep economic downturn risk assets could respond positively.
Debbie King is a multi-asset investment manager at Aegon Asset Management. The views expressed above should not be taken as investment advice.