Don’t Be Tempted By The Old Playbook

Transcript

This week, the Federal Reserve, the European Central Bank and the Bank of England are set to raise rates again, in their fight to tame high inflation.

1) Recession foretold

We see inflation coming down a long way in 2023.

But facing production constraints, central banks need to crush economic activity to get to all the way to their 2% inflation targets.

That’s why a recession is foretold, and that’s why we believe they won’t ride to the rescue when recessions do take hold next year.

2) Recession unfolding

We see recessions unfolding as higher policy rates compound the energy shock in Europe.

And the U.S. consumer is set to run out of pandemic savings next year, which will also add to the drag on economic activity via lower consumer spending.

3) Clinging to an old recession playbook

Markets expect rate cuts next year as recessions loom. But we think they’re clinging to an old playbook response by central banks. Why?

Well, this time central banks are trying to create recession to get inflation down. They’re not trying to avoid recession.

And that’s why we rethink bonds’ ballast role in portfolios and why we’re cautious on equities that don’t yet reflect this new recession playbook.

We underweight developed market stocks and long-term nominal government bonds, and we prefer short-duration bonds and high-quality credit.

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Major central banks will hike rates again this week: Getting inflation down means they need to crush demand, making recession foretold. We expect central banks to keep rates high as recession unfolds – not save the day as in the past. Yet, Treasury yields have slid as the market expects Federal Reserve rate cuts, with the yield curve inverting more. We think that incorrectly reflects hopes for an old recession playbook and stay underweight developed market stocks and long-term bonds.

Old playbook expectations

Notes: The chart shows the market pricing of future U.S. policy rates based on SOFR futures. The dark orange line shows the path as of December 6, 2022, versus the path as of Sept. 30, 2022, represented by the yellow line.

We think markets are pricing in rate cuts starting in mid-2023 (the dark orange line in the chart) because they think the Federal Reserve will ride to the rescue when recession hits – the old playbook. That view has made U.S. yield curves the most inverted since the Fed’s last rapid hiking cycle in the 1980s, with five-year Treasury yields falling more than two- and 10-year yields over the past month. That’s boosted stocks. We see core inflation falling further next year from current levels but think central banks won’t be getting it back to 2% targets. Doing so would require an even deeper recession, in our view, and we see them stopping short of such an outcome as the damage from policy overtightening becomes clearer. So we see central banks living with persistently above-target inflation – and they won’t be able to cut rates as quickly as markets expect, in our view.

We’re starting to see recessions developing. Fed hikes have caused U.S. housing sales to slump on surging mortgage rates while businesses cut investment plans. U.S. households have dipped into excess savings built up during the pandemic to fund spending: the U.S. savings rate hit a 17-year low in October, according to the U.S. Bureau of Economic Analysis. We estimate U.S. consumers could deplete their accumulated savings next year. We see spending slowing, worsening an already contracting economy, in our view. In Europe, we see higher rates adding to economic pain from the energy shock.

Stuck on the old playbook

We expect inflation to fall significantly from its current highs as energy prices stabilize and goods inflation falls due to easing supply bottlenecks. Yet, pushing inflation down to target would entail even deeper recessions, in our view. A case in point: Harder-to-solve constraints – like a labor shortage as workforces age – are driving the Fed’s inflation headache. That means the U.S. economy can’t sustain current activity levels without creating inflation pressure. We think the Fed would have to close the gap soon between where the economy is operating and where it can comfortably operate given these constraints. That’s why we don’t see central banks reversing course by cutting rates as recession plays out. They’re now creating recessions, not riding to the rescue as they did in the past.

The U.S. equity rally and yield curve inversion show that markets are clinging to central banks’ old recession playbook. Market hopes of easing have supported the equity rally despite Fed Chair Jerome Powell’s message that rates may stay higher for longer. We think stocks could fall again if markets stop expecting policy easing. The gap between market expectations and the Fed’s intentions will start to close over time, in our view. We see long-term yields surging as investors demand more term premium, or compensation for the risk of holding long-term bonds, amid persistently above-target and more volatile inflation, historically high rates, record debt levels and the risk of financial accidents. The UK gilt selloff gave a glimpse of the return of bond vigilantes. Any change to the Bank of Japan’s yield curve control policy could add to a return of term premium.

Our bottom line

We stick with our conviction that nominal government bonds won’t help diversify portfolios right now and stay underweight long-term government bonds. We look to the short-end, investment-grade credit and U.S. agency mortgage-backed securities for income. We’re underweight DM stocks because we think markets will price out rate cuts and earnings don’t reflect the recession foretold. We expect to turn more positive on equities sometime in 2023, after gauging how markets are pricing the economic damage we see ahead and market risk sentiment. That’s our new investment playbook.

Market backdrop

Stocks fell 3% last week and Treasury yields were largely unchanged even as the yield curve inverted to its deepest levels since the 1980s. We think market expectations for rate cuts had boosted stocks, and earnings don’t yet reflect the recession we expect. Lower long-term yields reflect that markets are clinging to the old playbook – where central banks counter recessions and long-term bonds work as portfolio ballast – and not seeing the risks of term premium returning, in our view.

Three major central bank policy decisions anchor the week. We think the Fed will keep rates higher for longer than the market is pricing. We see the ECB and BoE continuing to hike aggressively. We’ll also be watching to see if central banks’ quarterly forecasts are acknowledging the economic damage needed to bring inflation down to target.