Stubborn Conditions Pave the Way
As high inflation lingers, it provides further justification for the Federal Reserve’s plan of aggressive rate hikes – actions that will continue shaping the economic outlook.
With slowing economic growth and rapidly rising interest rates, investors face a challenging backdrop. The three major indexes – the S&P 500, Dow Jones Industrial Average, and Nasdaq each closed September recording their worst first nine months of a year since 2002.
There was little reprieve in fixed income due to rising yields – causing bond prices to fall as the two have an inverse relationship. In September, the 2-year and 10-year notes set new yield highs going back more than a decade. A common fixed income recession indicator investors watch for is a yield curve inversion, meaning short-term yields are greater than long-term yields, as has been the case since July.
After a challenging month, no one likes to look ahead and see so many indicators pointing to a recession. However, with the reality that the US central bank – and others around the world – intend to continue aggressively hike rates to bring down inflation, we believe that a recession is becoming increasingly likely.
Their ongoing warpaths against inflation, in conjunction with what we believe is an economy that is already showing signs of weakness, has resulted in the risk of recession in the US and other major economies having increased significantly.
In response, we are further working to de-risk portfolios and position for a slowdown, while continuing to monitor macroeconomic developments.
Cracks in the Credit Market
Credit spreads and swaps can be useful tools to provide insights for investors. Did you know that when evaluating swap spreads, institutional investors can glean the market’s perceived credit risk assessment by subtracting the sovereign rate from the institutions rate?
Recently, there has been extensive spread widening, but no signs of panic. For example, the 2-year German Bund swap spread is approaching levels last seen during the Global Financial Crisis, and while the spreads were wider during that time, it did precede a recession.
While credit spreads offer insight into the fixed income space, we believe widening spreads are generally isolated to Europe at this time. We are not seeing as much stress in US swaps but are monitoring for similar signs of credit stress in financial markets. Learn more about credit spreads and swaps in ‘Cracks in the Credit Markets’.
Europe’s Energy Crisis
The war in between Russia and Ukraine has put Europe into an energy crisis. Last month, Russia further escalated the issue by indefinitely closing the Nord Stream 1 pipeline, Europe’s main gas supply. While it’s always been a tool at President Putin’s disposal to highlight his feelings towards the West, it is straining Europe and consumers as they also battle slowing economic growth and high inflation.
This act comes as no surprise as we projected that energy supplies could be used against Europe and the West. While this is a potential positive for US natural gas companies, we are cautious on European investments broadly. We share more thoughts and views in ‘Europe’s Energy Crisis’.
- Economic Cycle
- The economy is moving later cycle with speed; a recession in the US is becoming increasingly likely; the Fed is on a warpath against inflation, as it has found itself badly behind the curve and is being forced by high and persistent inflation to tighten into an already weakening economy
- Stock Market
- US stock market volatility has dramatically picked back up; market weakness, coupled with relatively robust earnings growth, has improved valuations incrementally; however, equities remain expensive by longer-term historical standards; elevated valuations may be partly explained by robust corporate profitability, as EBIT margins have climbed to historical highs; rising input costs are posing a risk to the ability of corporations to maintain this elevated level of profitability; returns will be harder to come by and stock selection will be increasingly important
- Bond Market
- Interest rates have risen well off their lows reflecting shifting expectations on inflation, growth, and central bank policy; corporate and municipal bond credit spreads have widened, but not enough to make them materially more attractive at this time
- Important Issues on the Radar
- COVID-19: the worst of this economic crisis is behind us, and with multiple waves of the virus, including the Omicron variant, the attention is shifting to learning how to live with the virus; potentially impacting recovery, financial markets and currencies regionally
- Ukraine-Russia War: we believe an environment of elevated geopolitical risks over the coming months would entail a general risk-off environment; lending upward support to the dollar, gold, and commodity prices
- China’s Economy: China is an outlier regarding policy and has shifted to a gradual loosening stance while most of the developed world tightens aggressively; debt and property markets remain major issues; trade tensions continue to impact global trade and supply chains
- Inflation: a confluence of massive policy stimulus, tight labor markets, gummed-up supply chains, and rising energy costs are causing inflationary forces to broaden and become more entrenched than previously expected; conflict in Ukraine and lockdowns in China have added to price pressures
Sources: Wall Street Journal
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