Leading indicators and lagging reactions
While January brought the feeling of relief to financial markets, February brought renewed doubts. In early March many things look as if we are back to the motions of 2022. Most notably, the positive correlation and the negative co-movement between bonds and stocks have returned. A suspiciously strong February non-farm payroll report was followed by disappointing inflation numbers across the US and Europe. This, along with stronger consumption and continued services sector strength, has sent monetary policy tightening expectations back above previous peaks with hiking expectations now well above levels in late 2022. Disappointments relative to specific data expectations typically drive short-term market reactions but are also to some extent noisy signals. Longer-term trends in markets are driven by innovation, hypes, fundamentals, and the path-dependent formation of such fundamentals. Concerning the drivers of the current market, the most important factors again seem to be inflation and the central banks tightening cycle. As seen in figure 1, the Fed has now hiked the upper end of its target range by 450bps. Even without considering the simultaneous scaling back of the QE via QT, this is more tightening than at any time over the last 30 years. The level is also higher than at any time after the “Great Financial Crisis”. Market pricing has moved from a peak of 4.5% to closer to 5.5% (please see figure 2), and for the ECB to above 4%. Experiencing market over the recent 3-4 months did not feel or look like a “blip” but rather a significant rally and then reversal in government bond yields.
Figure 1: The fastest move in 25 years. The Fed Fund rate vs. US 2-year and 5-year GB yield
From the temporary peak on the 1st of August 2022, the Euro Agg high grade bonds iShares ETF lost 9%+. The Swiss AAA-BBB iShares ETF is down 4%+ and the US Agg iShares declined more than 5%.
In a decisive improvement of conditions compared to a year ago, the key question for markets has changed from when US inflation will stop increasing to why US inflation has not come down more. In Europe the situation is complicated by the many well-intended but inherently populistic income assistance packages and transfer income increases. Still, as arcane as many countries’ political systems seem, the tough reality of the consequences of monetary policy tightening should soon be in evidence. As we will return below to the question of the delay in inflation normalization, it is probably the fact that it is “normal” for such things to take time. In this context, it is worth remembering that the most obvious difference between 2022 and 2023 is that the Fed had not even started hiking by the end of February 2022. With 425bps of hikes implemented and another 75-100bps priced, another difference is that where the Fed needed to wake up in 2022, they will need to cool down in 2023. With inflation indicators continuing down and employment and services sector inflation being a lagging indicator, a continuation of 25bps per meeting until the middle of the year seems like a likely path to us. The Fed Chairman seem to differ. In his presentation to The Congress Powell made considerations of data developments over a time frame of only a few weeks. Such short-term thinking means that long duration bonds remain at high risk and that so-called high yield bonds are likely to deliver better and more stable returns than government bond indices.
In our growth strategies, with up to 100% equities, we hold equity allocations close to maximum levels, with corresponding underweights in high grade bonds. In EDGE Sustainable Growth, these positions are concentrated in the low pollution, high growth sectors, such as IT and Healthcare.
In our balanced multi-asset strategies, we hold equity allocations close to maximum levels and maintain significant holdings of high yield bonds where yields are now often above 7%, while BB rated bonds account for more than 50% of such positions.
Across our Global Fixed Income Opportunities portfolios, we remain close to a maximum allocation to high yield bonds in both traditional mandates and our mandates with a focus on sustainable and ethical investments.
What is leading and what is lagging in the current cycle
Over recent weeks, the apparent end to positive surprises on inflation and inflation-related data has led to a repricing of market expectations for policy hikes from the Fed and the ECB. Across the curve, yields have moved up and the US, and German 2-year yields are now at the highest level seen since the Great Financial Crisis. One important question therefore is when inflation will normalize. Another even more important question is what the Fed and ECB will do until this happens. If one believes, as we will argue, that tightening takes time to work, then the answer to the first question is that not enough time has yet passed for the bulk of the tightening administered until now to take effect. If this assessment is even close to correct, then the reason the Fed has slowed its pace of tightening could possibly be that they wish to be seen as ramping up tightening until inflation has decisively turned. This would be in line with our previously stated assessment that after everyone got surprised about the inflation spike (the consequences of the central banks' misplaced complexity), we are now in a phase of “seeing is believing”. Hiking by 25bps per meeting in this context puts Powell in the relatively more comfortable situation of being able to hike at every upcoming meeting until the summer, and this way implement what one could call “meaningful and gradual tightening” while claiming to be a “prudent realist” or a “cautious optimist”. It also fits with Powell’s statement on the 30th of November 2022 that inflation has somewhat moderated, but that more evidence is needed and that one should be cautious about believing in inflation forecasts. However, judging by Powell’s statements to The Congress, in early March, it looks like he sees his job maintaining uncertainty on Fed moves and markets are now pricing a temporary return to 50bp hikes.
Figure 2: CME market implied Fed target rate probabilities as of March 2023
Still, markets are expecting a total of 100bps of hikes and the fact that this is now prices, is one of the reasons we still see it as more likely than not that stability will resume also in equities, despite the recent dramatic move up in government bond yield curves. The economic effects of the move are not yet felt completely, but what we can see is that the re-pricing is happening across the intended markets and therefore should work across both the real economy and financial markets (not least credit interest rate levels).
Figure 3: U.S. fixed rate mortgages have moved back up to their multi decade highs
As seen in figure 3, US mortgage rates have moved back up towards their earlier peak levels. More important than where they were a few months back, is that this is a different level from what was seen just 12 months ago and from the level markets had gotten used to in the preceding decade. This has led to downwards pressure in one of the key leading parts of the US economy, namely the housing market. Both construction activity and price levels have come under pressure. In figure 4 we show the price change measured on a year over year basis in the CS index. Here, the bubbly growth rates have been tamed as the recent 6 months have shown outright declines in prices. Depending on the chosen measure prices are now off by 3-6% from their all-time peaks. For now, this is nothing significant for collateral values and only very modest in comparison to the increases seen after the pandemic. It is, however, a serious break on what used to be a sector delivering a significant boost to both nominal wealth and the general feeling of financial well-being across the US middle class. With continued declines in prices expected, this is likely to develop into a significant dampener on discretionary spending across restaurants, entertainment and other labor-intensive sectors. rom the perspective of inflation measurement, there are several links from house prices to inflation measures and some of these have natural built-in lags. An important component of PCE and CPI inflation measures is housing-related expenditure. These come in the form of rents and in the form of the measure of the rental-equivalent cost of living in one’s own house, the so-called owners’ equivalent rents, which for urban homeowners have increased from 2% YoY in early 2021 to 8% in the most recent release. As for the rent component, this moves up gradually as rental contracts get adjusted up and people change homes during the economic cycle. The latter works with a lag as it is a “constructed measure of the similar cost estimated for people who own their own homes, as the majority of the US middle- and higher-income population does".
Figure 4: U.S. house price inflation is moderating
Another area with large and persistent lags in adjustment is the labor market. Of all the data creating nervousness, the labor market is still among the most important, both for the Fed and for markets (as reflected in movement in bond and equity markets when the US labor market report is published). This is very intuitive as wages are a significant proportion of costs. It is however also an area where a lot of research has yielded few tangible results. Unemployment was trending down before the pandemic, spiked up during the early phase and is now trending down again after the pandemic. There is an abundance of statistics showing that labor market participation has gone down and plenty of explanations why. Nevertheless, there is very little knowledge about what happens in the labor market in the short term. One reason is that much of the data is survey-based, another reason is that weekly jobless claims have been adjusted heavily for political reasons in recent years and typically get adjusted during recessions. As if this was not confusing enough, the best intentions are also often drowning in the simple fact that the labor market is very seasonal and that the seasonally adjusted methodologies used often produce large swings and adjustments to already published data. This is one of the reasons that the Non-Farm Payroll, with its large market impact, is known both as the “King of Macro Data” and as the “Non-Farm Lottery” among traders. Where there is consensus both among academics and practitioners is that the labor market should be a lagging indicator and that it appears to be so. For what it is worth, we can see that the published data indicates that wage pressure is moderating. Both Average Hourly Earnings growth and the employment cost index is thus showing a clear decline in annual growth rate.
It is always tempting to try to explain local development with local policy and this is obviously the case in the short end of the government bond curve where the central banks set the level of rates.
Figure 5: Declining cost pressure in the U.S. labor market
Moving further out on the curve, the movements are rather global in nature. This is easily seen in figure 5 where we show the development in government bond yields over the last 3 years which, at the time of publication, correspond closely to the pandemic panic and the post pandemic period.
Figure 6: US and European government bond yield 3-years parallel move up
European inflation has erupted later than US inflation and peaked only recently; we are still rather less concerned about this, as we find it entirely natural given the policy design in Europe. By this we mean that the policy framework by design dampens the business cycle, and the specific packages which increasingly populistic policymakers across the continent put in place prevent the price adjustments and demand destruction from taking place. We do however find it problematic that the very policymakers who are claiming to help the poor and vulnerable in this way harm exactly these groups less able to help themselves. Nonetheless, this is a topic for a different forum. For now, it should simply be noted that while we do not think it is necessary to hike to 4% to get inflation down, we do see this as a level the ECB may reach, not least because this coincides with the ECB’s published expectations. We hope that inflation rolls over in coming months and again starts trending down going into 2024.
Across asset classes and the broader markets, contagion has been less widespread. Government bonds have declined, and emerging market equities have been hit hard after a very limited rebound relative to their long underperformance, despite the positive growth indicators coming out of China.
Figure 7: US high yield and EMBI (OAS) Spreads show limited contagion from GB yields
The long standing USD and US rates dependency of this sub-asset class has dominated. For developed market equities the hit has been significant, but so far mild relative to the recovery and to last year’s corrections. In our view, a reason for this is the progress of the inflation normalization mentioned above, which had also helped limit contagion from government bonds to high yield bonds and credit spreads. We thus once again look close at the credit markets to assess how much contagion to expect and to see if we are facing a self-reinforcing negative cycle. For now, our assessment, supported by our algorithms and the spreads seen in figure 6, is that this is not the case. We therefore remain invested in equities and high yield bonds with shorter duration rather than government bonds. In our ethical credit portfolios we have maintained very short duration.
Mads N. S. Pedersen
Managing Partner and CIO