The Tectonic Tussle. View from the Fixed Income Desk.

The tectonic tussle for supremacy in investors’ psyche continues apace. It seems almost every week we race from the doom and gloom of recessionary fears, to the doom and gloom of inflation. Treasury bond volatility has increased as we race from one extreme to another. Risk assets (and one could almost include Bunds and Treasuries in this bracket now) are somewhat confused.?Is lower growth good because it means lower inflation and less interest rate rises, or is it unwelcome due to the subsequent decline in credit metrics? I think we can all agree that high and sustained inflation and/or a hard recession are the two outcomes we don’t want.

Non-farm payrolls much higher

Non-Farm Payrolls exceeded expectations, coming in at 372,000, versus consensus of 265,000[1]. Wages remained relatively flat. Last week’s Jobless claims were also higher. What can we take from this? The market took it as a sign that we are further away from recession, which markets have been pricing in over that past week or so, and it’s now inflation’s turn at the front. Treasuries sold off and the 10-year has almost gone full circle from 2.80% at the lows around a week ago, to 3.09% at the end of last week. Now we are back at sub 3%, and the merry go round continues. A 75bps hike is now fully on the table this month, with 50bps in September - again it’s going to depend on the data, and it is too early to make any bold predictions given the potential for summer volatility.

I am still expecting inflation to decline towards year end, and a mild recession (this year or early next year). To put this into context, I see a mild recession as much the same as a slowdown. With strong employment, and a resilient consumer, it is hard to really talk about a hard/soft recession, other than the technical aspect of two consecutive quarters of negative GDP growth.

What happening with inflation?

Consumer Price Inflation in the US is out on Wednesday and again, it is black and white. A weak number and we begin to look at less inflation and perhaps less growth, a strong number and we are back to speculating that the US Federal Reserve will have to be more aggressive. The latter should not really be an option anyway. Kansas City Fed President Esther George recently announced “It is unclear just how high rates will need to move in order to bring inflation down”, so it would be premature to begin to price in a less aggressive trajectory until a pattern of consistent drops in the month-on-month inflation number have been realised. It seems unlikely that Treasuries will rally significantly in this environment, especially whilst the Federal Reserve is still hiking.

The US consumer continues to spend. Bank of America recently posted credit and debit card figures according to a recent Bloomberg report. Consumer spending rose 11% year over year in June (versus 13% in April and 9% in May). Bank of America saw a continuation of spending on travel and entertainment post COVID, but inflation is beginning to have an effect as seen by lower-income household spending on petrol climbing to 9.8% from 7.7% in February[2].

How are we positioning fixed income portfolios?

I am positive on fixed income.

I believe that we are at the beginning of a new fixed income cycle, and it is at these times of extreme negativity that opportunities arise. Having said that, we do have some short-term headwinds. It’s summer, and liquidity is poor. Economic numbers in the second quarter may disappoint, and that could lead us back to fears of recession again. For the market to rally, we need to see investors coming back into the asset class, and that is going to be dependent upon more clarity on where we go from here. That will take a few months to work through.

We are therefore cautious over the very near term and have hedged our global fixed income strategies for both duration and credit risk. That is slightly counter intuitive, but I do think the stagflation argument is a short-term risk for the next couple of months. Rates in the US will continue to go up, and credit is also likely to be under pressure.

For our broad-based global fixed income strategies, we have been buying longer duration AA and A bonds in the US. I continue to believe that there is a huge opportunity once we begin to see inflation in the US decline, and a less aggressive path of interest rate increases.

I continue to be cautious on Europe for now, given the energy situation.

Outlook

There is no real change. Short term uncertainty as we move through the summer. Potential Q2 results headwind, increased uncertainty as the market flips from inflation to recession fears. The US will probably decouple from Europe to some extent, but overall cautious for the next few months. I do think that in the fourth quarter, we will begin to see some of the trends that we are positioned for, unfold, and so there is light at the end of the tunnel!

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[1] Tradingeconomics.com, June 2022

[2] Bloomberg, 8 July 2022