Calls for caution

Frontiers 

Markets are probing the frontier between what constitutes a US economic soft landing and a recession. As usual, the rates market is leading the exploratory expedition, having already priced in aggressive cuts in policy interest rates in the year ahead. By the end of 2025, the Fed’s key policy rate is expected to be targeted at 3.0%, a full 250 basis points (bp) below where it stands today. The market expects that process of rate cuts to start on 18 September, pricing around a 70% chance that the Fed cuts by 50bp, although a 25bp reduction seems more likely. Looking out along the forward curve, we can observe four 25bp cuts priced in for the remainder of this year and five additional cuts in 2025. The next step on this journey is how the Fed presents the rate cut on 18 September – its Beige Book released on 4 September was downbeat in terms of activity and the jobs market.

Real rates 

Is a recession priced? It’s not clear that it is yet. Real short-term rates are expected to remain positive on the assumption that the core personal consumption deflator inflation rate settles back to the target of 2.0%. A 1% real short-term policy rate is higher than the average of the last 30 years (0.6%) and much higher than the average of the last 20 years (-0.4%). The experience since the late 1990s has been one of prolonged periods of negative real interest rates interrupted by sharp increases in real rates during Fed tightening cycles. There is little evidence to suggest that 1% real short rates represent any kind of equilibrium. Going back to the 1980s, real short rates were substantially higher, but macroeconomic volatility was generally much higher back then and the structure of the economy has changed markedly (more regulated labour and product markets, deeper capital markets and digitalisation’s impact of on everything). In a recession, real short-term rates would need to be lower than currently priced, meaning lower nominal rates (back to 2%?). Only then could longer-term bond yields move significantly below what I think is the current fair value range of 3.5%-4.5%.

Economic cool spots 

For now, the economic numbers are not aligned with a full-blown recession. The US economy grew at an annualised rate of 3% in the second quarter (Q2). Recession is not the central view of AXA IM. But there are concerns about a slowdown and these are focused on the manufacturing sector and the labour market. The latest data points to an ongoing decline in job openings as the post-pandemic jobs boom unwinds. The unemployment rate increased to 4.3% in July and the pace of non-farm payroll jobs growth has slowed steadily in recent months. I will have sent this note out prior to the release of the August employment data, but this will be important for market expectations on the soft landing versus recession debate.

Bottom left 

The manufacturing data has shown softness for a while. The Institute for Supply Management (ISM) manufacturing index printed at 47.2 in August. This is below the ‘rule-of-thumb’ breakeven growth level of 50 for this index. Moreover, the momentum is negative with 47.2 being below the average of the index prints over the last six months. So, both the level of activity and the momentum is negative. Historically, this would be described as a slowdown or even a recessionary phase of the cycle. From a markets point of view, rates have performed well during this phase in the past, while credit and equity returns have generally been below their long-term averages.

Year of the bond 

Recent market performance is aligned with slower growth. The shift in rate expectations in Q3 generated very strong return numbers in the bond market. As we have expected for some time, the US yield curve has started to normalise – the gap between two-year and 10-year Treasuries is now close to zero compared to 100bp in early 2023. But yields have fallen at all maturities over the summer.

Between 30 June and close of business on 5 September, US Treasuries delivered a total return of 4.8%, US investment grade credit posted 5.1% and US high yield 3.9%. Other bond markets also had their best run of the year over the summer. You know you are in a bond bull market when there is a cacophony of “markets have moved too far” comments. So far, Q3 has pushed up the year-to-date total return numbers – high-quality credit returns are between 3% and 4%, high yield returns are running above 6%, and hard currency emerging market returns are close to 7%.

Volatility signals 

August and September’s first trading weeks saw increased equity market volatility. Since 30 June, the total return from the MSCI World equity index has been 1.9%. For the S&P 500 it has been 1.03% and for the Nasdaq, -3.3%. Even though total returns in the bond market have been good, credit excess returns have faded compared to the first half of the year. The excess return for US investment grade bonds relative to the government curve was 10bp since 30 June, compared to 13bp in Q2 and 103bp in Q1. For US high yield, the excess return in 2023 was 9.1%; this year it is running at a more modest 2.9%. I still like credit as an asset class but the ability of credit to deliver returns substantially more than rates when credit spreads are already thin, and the economy is slowing, must be questioned. If you take the ISM data seriously and couple that with a weaker labour market, the conclusion is a slowing economy that will raise the uncertainty over credit stability and corporate earnings growth going forward. Risk premiums are low. One could conclude a more cautious approach is required.

Adjustment from expensive 

US markets have been more expensive than the rest of the world. The justified price-to-earnings valuation premium of US stocks rests both on the preponderance of growth stocks in the US market but also on the aggregated rate of growth of earnings. The growth stocks story isn’t going away, but earnings growth might be at risk from a slower economy. US credit spreads have been, mostly, narrower than in other credit markets. If the economy is downshifting from 3% GDP growth, low unemployment, and double-digit earnings growth to something softer, then some rebalancing of valuations between US and other markets might occur. Another consideration is politics. The political climate is not great anywhere, but the US has an event upcoming which creates uncertainty over the direction of the policy agenda.

Inertia 

The lesson learned in recent years is that economic inertia is not something that models always pick up easily – the inflation shock went further and lasted longer, the post-pandemic jobs boom lasted beyond what seemed likely, and maybe now the slowdown might go further, taking interest rates lower and potentially risk premiums higher. A theoretical 60:40 balanced portfolio of equities and bonds would have performed well in 2024. If risk asset performance starts to deteriorate, bonds are in a better position today to provide some cushion of portfolio support compared to the case for most of the last 20 years.

(Performance data/data sources: LSEG Workspace DataStream, Bloomberg, AXA IM, as of 5 September 2024, unless otherwise stated). Past performance should not be seen as a guide to future returns.