The US Federal Reserve continues to raise rates at a fast pace, as soaring inflation continues to dominate the attention of policy makers despite growing concerns about growth. The Fed hiked its benchmark rate by 0.75% again in July, following a similar move in June, taking the total number of increases this year to four.
In this context, many questions linger in the minds of investors. How much longer will the Fed keep its foot on the tightening pedal? Are we already in a recession? What does all this mean for fixed income as an asset class?
The statement and the press conference that followed the latest meeting had something for everyone, and in general it seems that the overall market interpretation of the Fed tone (at least looking at the behaviour of risk assets) was relatively dovish. We would disagree with this assessment. At the beginning of the press conference, Fed Chairman Jerome Powell clearly stated that the Fed is still firmly committed to bringing inflation down to the 2% target. We expect the Fed to remain hawkish for the time being, despite the numerous signs of slowdown we have been highlighting in recent months.
The Fed has now recognised that they are starting to see slower growth and that is a welcome development for investors looking for an eventual pause in hiking, although it will be sometime before this happens. Slowing consumer spending and clouds over the housing market are just two of the elements indicating the potential for a material slowdown, and the negative print for US GDP in Q2 (which may bring the country into a “technical” although still not officially recognized recession) gives a key tangible sign of this.
Risk of a deep recession
The Fed (and US government officials) clarified that they do not believe the US is in a recession yet, highlighting the strength of the job market with low unemployment rate and positive payroll numbers. We would also disagree with this assessment. Job market numbers we see today are backward looking. Indications from many US companies during the recent earnings season showed that they plan to pause hiring, or even start to cut jobs. Past recessions typically started with positive payroll numbers.
We also saw some diverging aspects concerning guidance. On the one hand, Powell stated the willingness to proceed on a meeting-by-meeting basis, abandoning strict forward guidance, and returning to a fully data-driven approach. On the other hand, he reinstated the latest guidance coming from the latest available dot plot (3.5% by year end and 4.0% in ’23). Something for everyone, and not necessarily dovish.
To sum up, we continue to see a Fed very determined to bring down inflation. All the signs point to growth continuing to slow and the risk of a deep recession. As a result, the Fed is likely to continue to hike into a recession in the coming months, until major (and probably more painful) signs of weakness appear.
Out of sync with fundamentals
The recent rally in risk assets is therefore out of sync with economic indicators. We regard the bond market as a more accurate indicator of where fundamentals are today. The 2s10s segment of the curve has reached the highest degree of inversion since the 2000s and the 3 months 10 years looks likely to follow suit. Inflation will eventually come down, thanks in large part to falling growth, and the Fed will have to ease policy. The key for us is that the Fed is still hawkish today, and risk assets may have misprinted the current level of hawkishness.
What does this mean for our portfolios? We continue to see significant value in government bonds in the United States, Australia and also in South Korea and New Zealand. The recent fall in global government bond yields is just the start, in our view. For now, we prefer the long end of the curve which is likely to continue to invert as the Fed continues to put upward pressure on the short end and longer-term growth prospects continue to deteriorate.
It’s estimated that it takes approximately 12 to 18 months for rate hikes to filter through to the real economy therefore we have yet to feel the full force of the tightening thus far. We’re also finding opportunities in the HY market, but we remain wary that the recent rally has gone too far, and we expect further volatility as recession fears return. We thus prefer to stay in defensive sectors, preferably via secured issues. When we venture outside defensive areas of the market we prefer shorter duration instruments, idiosyncratic trades, or sector catalysts. At these wider spread levels, we are also seeing greater value in parts of the investment grade market, for example in real estate.