September 05, 2023
September 05, 2023
Hard Walk Towards a Soft Landing
September 05, 2023
August has been rough as global equities underwent a market correction. The last few days of the month helped markets recoup some of the losses suffered as labour markets appeared to be cooling after the pull back in U.S. job openings. The S&P 500 Index returned -1.6%1 (USD) while the MSCI Europe (EUR) Index fell 2.4%1 and MSCI Japan Index (JPY) remained flat at 0.0%1. Emerging markets were hit, with the MSCI EM (USD) Index down 6.1%1. China suffered given turmoil from the property market. Sector performance was negative across the board with only MSCI ACWI Energy (USD) Index generating positive returns. The US 10-Year Treasury yield has been hovering above 4% this month, reaching a peak of 4.35%2, a level not seen since 2007 and closing the month at 4.1%3. As a result of the sell-off, the VIX Index rose to end August at 13.63, after peaking at 17.9%4 mid-month.
The U.S. labour market appeared to be losing steam in August, as the JOLTS1 data reported a decline in job openings to a low not seen since 2021. However, the Jackson Hole Symposium saw a hawkish tone from the U.S. Federal Reserve. Fed Chair Jerome Powell commented on inflation still being too high for comfort, despite labour market cooling and indicated policy may need to be kept restrictive for longer to reach the elusive 2% target, thereby dampening any expectations of a rate cut in 2023.
The Fed appears more concerned about bringing inflation down, than the prospect of a recession – rather emboldened that a soft landing may be within their reach. This supports the argument that policy rates are likely to remain elevated for longer and decline only marginally when the Fed does eventually begin to ease. As a result of this, bond yields have been on the rise, despite the fact that the Fed is nearing the end of its rate hiking cycle. Factors such as higher-for-longer rates, the shift towards a soft landing scenario and the fact that lower-yielding, long duration bonds are an expensive hedge against recession, seem to have been priced in by investors. Given that backdrop, we have conviction in our barbell strategy to own high-quality, short-duration assets alongside higher-yielding, high-yield credit, asset-backed securities and emerging markets for our bond allocation.
Over the first half of August, we took advantage of softening prices and added risk to the portfolios, as we believe real interest rates are still not restrictively high, consumers are not stretched in terms of income or debt and business balance sheets are not leveraged. We still see many investors have yet to reposition from a very pessimistic low risk portfolio allocation and when they do, this will likely further support market prices. However, we reduced overall portfolio duration as recession uncertainty balances potential upside from inflation. We made the following tactical changes in August:
Post the recent rally, we closed out the position in Brent as we believe that it has limited upside potential in the absence of a fresh catalyst. As Chinese and European growth remain under pressure, global demand might struggle to surprise to the upside after the summer travel boom.
USD Investment Grade
We moved from neutral to underweight USD Investment Grade credit, on lingering duration and spread concerns. The prospect of a soft landing and attractive all-in yields should further support risk appetite for IG credit. However, compared with EUR IG credit, the high duration of USD IG is likely to result in less attractive total returns in the future, if we see a further rise in yields. That said, USD IG spreads tightened considerably throughout the summer and we see limited potential for further aggressive tightening.
EUR Investment Grade
We moved from positive to neutral EUR IG, as we prefer its shorter duration compared with USD IG. Spreads remain well above the longer-term median, which reflects the more muted growth environment and recession concerns. This, together with the spread tightening observed in July, makes the total return outlook more balanced.
Emerging Markets Hard Currency Sovereign Debt
We moved from overweight to neutral Emerging Markets HC Sovereign Debt, to take profit. We prefer EM Local Currency Sovereign Debt, which can provide diversification* benefits and potentially less interest rate sensitivity, along with higher yields than traditional safe fixed income IG allocations in the current environment.
We moved from neutral to underweight on Chinese equities as structural issues make a stimulus-led rebound harder to achieve this time. Earnings trend has been stagnant since 2013 and structurally declining since 2018, which is hard to reverse with macro headwinds intensifying. Additionally, deflating of the housing bubble could lead to wealth destruction and growth drag for years.
The index performance is provided for illustrative purposes only and is not meant to depict the performance of a specific investment. Past performance is no guarantee of future results. See Disclosure section for index definitions.