The concept of a soft landing for the US economy is making more and more sense to some Wall Street pundits. The debate on the outcome of the restrictive monetary cycle is more alive than ever, especially after the meeting of the Federal Reserve and the statements by its president, Jerome Powell. The top leader of the US monetary institution ruled out that the US economy will enter a recession in 2023.
“It is something very positive that the unemployment rate is the same that it used in March 2022, when we began to implement measures, with 3.6%… It is a blessing that we have achieved some disinflation,” he said before assuring that he rules out that GDP goes into negative territory in annual terms. “We have not sought to raise unemployment, not that we have aimed for that, but you have to be honest with the historical record, which suggests that when central banks intervene to slow the economy and reduce inflation, the result tends to be a weakening or labor market conditions,” he added.
The latest CPI report from the North American country showed that inflation is trending downward more decisively after slipping below 3% in June and suggests that it will continue the same path in July. At the same time, the resilient activity data has continued to surprise many. Housing starts, building permits and home sales appear to have bottomed out, while the service sector continues to perform well.
In Europe, the overall CPI fell from 6.1% to 5.5%, while the core CPI was unchanged in June at 5.4%. Compared to the Fed, the ECB has a little more to do to make the trends so compelling. “However, we cannot ignore the fact that headline CPI inflation peaked about 8 months ago, almost double the last reading,” says Felipe Villarroel, portfolio manager at Twenty Four (Vontobel boutique). .
In terms of GDP, the Bloomberg consensus for US quarter-on-quarter growth is zero in the third quarter and slightly below zero in the fourth. Thus, in this scenario, inflation falls to more reasonable levels, while growth falls significantly below trend, but without a recession. If this is the case, the Fed should feel comfortable cutting rates in the not too distant future as inflation falls towards target and the policy rate is well above the neutral rate.
The impact on fixed income assets
Villarroel comments that, faced with a soft landing scenario for the economy, Treasury bonds should be well supported in this scenario, although the curve is already quite inverted. “It is hard to see how much the 10-year note could continue to rise, but absent a hard landing and with the 10-year note yield already around 175 basis points below the policy rate, the room for a A further increase could be limited”, he affirms.
In other words, Treasuries would be well-supported and offer “reasonable returns”, but whether or not they outperform other asset classes “is another matter entirely”, as the Vontobel boutique manager adds. In this scenario, by definition, the impact rates cannot be too high, since, if it happened, it would not be a soft landing but a hard one. Therefore, this hypothesis should be favorable for spreads in those markets in which they are below their historical averages.
“There are even reasons for spreads to behave well even in markets where they are not especially cheap, as lower inflation favors real yields and nominal yields remain near their highest level in a decade.” Villarroel stands out. In addition to the rally in underlying yields, total returns would benefit from spread compression and higher carry than Treasuries.
Debt in economy with positive real rates
Pascal Gilbert, fund manager at DNCA (Natixis IM), has a slightly more negative and cautious view of the evolution of bonds and fixed income after the rate hike. “Starting at the end of 2023, when you should raise the question of maintaining the main rates at the levels reached in 2023 or the other way around, since the financial markets anticipate a sharp drop in them. Any investor who, like us, is prudent , you should be wary of this drop in yields already incorporated into bond prices,” he warns in a note.
Gilbert believes that it is still necessary to maintain a low global exposure to fixed income but without neglecting the opportunities. “We believe that given the great uncertainties (geopolitical, climatic), the risk premiums offered on long-term returns are too low, and sooner or later they will increase, causing an increase in returns. For our part, if we maintain an ex position Reduced to fixed income, we prefer to keep titles on real rates, mainly in the Anglo-Saxon countries where positive rates are close to potential growth, which we couple with short positions on nominal rates, mainly in the Eurozone”, he highlights.
Attention to emerging bonds
For Capital Group, with this framework in which the economy and markets find themselves, Looking ahead to 2023, its long-term return hypothesis for capital markets shows a more attractive investment environment. “In our view, improving corporate fundamentals and currency effects more than offset the potential slowdown in global economic growth, especially in China,” they comment in a commentary on the matter.
After the sharp fall in the US equity market, valuations are now more reasonable, in the manager’s opinion: “We are bullish on non-US equities, which should benefit from the combination of an increase in the dividend yield, the expansion of multiples and the weakening of the dollar.”
In terms of total return, the investment solutions team finds attractive opportunities in emerging market debt. “The yields are higher than in other areas of fixed income, and the dollar could favor the profitability of debt denominated in local currency,” they conclude.
