Repositioning for the next leg
Over the last several months we have reiterated our view that economic growth would start to slow throughout the year, and positioning changes would be warranted as the economic cycle progressed. Although economic growth remains strong, early signs of a slowdown have started to surface, with the yield curve now flat, and a growing conviction from our CIO team that business sentiment measures will begin to fall in the coming months.
Meanwhile, the move in rates in the first three months of 2022 has been extraordinary, as markets have moved to price in a more aggressive Fed. The over 120bp rise in 10-year yields since the beginning of the year has surpassed most strategist’s year-end expectations in the first 14 weeks of 2022.
As a result of our outlook for growth and rates moving forward, last week we made several changes to our equity and fixed income positioning.
Equities: Getting more balanced
In our US equity sector preferences we have become more balanced between cyclicals and defensives. We downgraded consumer discretionary, financials and industrials from most preferred to neutral. To accommodate these changes, we upgraded healthcare from neutral to most preferred and utilities from least preferred to neutral. That leaves us with most preferred views on energy and healthcare offset by a least preferred view on consumer staples.
These changes were prompted by our growing conviction that economic growth will continue to slow over the course of the year due to the impact of higher interest rates, inflation, and reduced pent-up demand from the pandemic. Specifically, we expect the ISM Manufacturing index—a key measure of business activity and sentiment—to trend lower over the course of the year. Historically, a falling ISM index tends to be a relative performance headwind for market segments that are more tied to economic growth. The flat yield curve—minimal difference in yields between 2-year and 10-year Treasuries (it is currently only 0.2%)—also tends to be more supportive for defensive sectors, which are less correlated with economic growth.
We remain most preferred on energy given our belief that stocks in the sector are still cheap and seem to only be discounting an oil price in the mid-USD 70s. Oil price downside is likely limited because oil supply is not increasing fast enough to keep pace with growing demand. Our new most preferred sector of healthcare should be further supported by the fact that pharmaceutical stocks remain inexpensive. Meanwhile, on drug price regulation, the most likely scenario is either a bill will pass with only moderate drug price reductions, or the issue will fade from the policy agenda if Democrats lose control of Congress in November.
To be clear, a recession is not our base case and our positioning does not reflect anticipation of one.
Still, we think that equities will be somewhat range bound until investors gain more conviction in: how far inflation will fall, how high the Fed will raise interest rates, and the impact of Fed rate hikes on economic growth. It will be some months before investors know the answer to these questions. But stocks could move a bit higher within our expected trading range, especially if first quarter earnings results are resilient and inflation begins to peak soon. Our year-end S&P 500 price target remains 4,700.
Fixed income: Repositioning after the spike in rates
Although outside tail risks remain for rising interest rates if inflation continues higher after this week’s CPI report, we believe most of the bearish trend in yields is behind US for 2022. As a result, we are lowering our largest rising rate allocation, senior loans, from preferred weighting back to neutral, while reducing our least preferred in US government.
CIO established a long senior loan position versus 10-year Treasuries on 20 May 2020, which has been a strong return contributor. Senior loans have outperformed high yield by over 4.5% in 2022 alone. Although we acknowledge that credit fundamentals, such as lower leverage, low default rates, ample interest coverage and retail demand are sound, and we still believe the sector on a fundamental basis will generate carry, most of the positive news has been priced into the market.
Large interest increases have not solely occurred in US 10-year yields. The 2-year Treasury yield experienced the highest quarterly yield rise (~160bp), the largest quarterly rise in over three decades. These rate moves, combined with the funding issues during the Russia-Ukraine crisis in early March, have negatively impacted the short-end of the investment grade (IG) corporate curve. We may not have seen an all-time high in the short-end, given market uncertainty over inflation, but do believe that the velocity and magnitude of the rise in the 2-year yield is now behind us. We are therefore moving up in credit quality and shifting into 1- to 3-year IG corporates. With over 3% yield, this sector earns incremental carry akin to longer bonds without taking on the inherent interest rate risk or volatility. For those looking for liquidity and higher principal protection, the short end offers the largest buffer we have witnessed over the past several years following its large underperformance in the first quarter. We therefore maintain our barbell approach heading into 2Q, combining preferred securities alongside 1–3-year IG corporates and moving back to neutral on senior loans.
Co-authored with David Lefkowitz, Head of Equities Americas, and Leslie Falconio, Head of Taxable Fixed Income Strategy Americas