With the mismatch between asset market pricing and a potential recessionary outcome, fixed income has become increasingly attractive
by IFAST RESEARCH TEAM / pic AFP
MARCH was a chaotic month as the sugar rush that markets experienced late last year continued to fade as fears of a banking crisis overwhelmed market euphoria. Global equities were down for the first half of March before rebounding over the past two weeks. As optimism starts to rebuild, we cannot help but ponder the possibility of a false dawn as a soft-landing look increasingly distant after recent developments.
We now see a higher risk of a US recession. Drags from Federal Reserve (Fed) rate hikes are building as the delayed impact from last year will continue to weigh on growth throughout the year. Markets and the Fed disagree on the path of interest rates but we believe the latter is right. The continuing tightness in the labour market and sticky inflation will make it a daunting task for the Fed to cut rates this year, which means the economic damage from higher-for-longer rates will snowball. Already, leading indicators are pointing towards a slowdown in the economy (see Chart 1).
Recent happenings across the US banking sector have also materialised as economic drags. While the fallout from the bank turmoil has been limited mostly to regional banks, credit conditions in the US will likely deteriorate as banks turn more conservative.
Before the Silicon Valley Bank (SVB) collapse, we see banks already tightening their lending standards for business loans as growth deteriorated. The tightening will accelerate as financial stress and regulatory pressures mount. On the consumer side, lending standards for auto and credit cards have also tightened, albeit more recently. With the expected contraction in business and consumer loans, we foresee a bigger credit drag in the second half of 2023 (2H23), which will have negative implications for the labour market. In short, the headwinds that are emerging in the US credit markets will gradually weigh on growth.
We believe higher odds of a US recession raise the risk of a global recession as Europe’s and China’s growth lack the horsepower to uplift the rest of the world. Like the US, Europe is facing the lagged economic impact from last year’s jumbo rate hikes, albeit slightly delayed, while inflation persistence will likely necessitate a higher-for-longer policy rate, weighing on regional growth. While China has seen an economic bounce, its positive spillover may be questionable. Tourism is picking up but the rebound is largely domestic, while the recovery in international tourism remains slow. Moreover, export and Manufacturing Purchasing Managers’ Index (PMI) data from Asian economies point to a slow and limited recovery in China’s demand.
With the march towards a US — and global — recession looking to pick up pace, we think this risk looks underpriced right now and there are several tell-tale signs. The more obvious ones are in asset pricing and consensus estimates: (1) Equities have rebounded off their 2022 lows even as macro data have moderated; (2) the price decline and valuation contraction (valuations have even expanded in some regions) are far from recessionary level declines; (3) forward earnings estimates for both financial year 2023 (FY23) and FY24 are looking unrealistic given weaker growth outlook; and (4) credit spreads for bonds, particularly high-yield bonds, have narrowed after widening last year and are nowhere near recessionary levels.
The mismatch between asset market pricing and a potential recessionary outcome is jarring. With markets still pricing in a soft-landing, there could be further downside and greater volatility ahead as a recession material ises. We see greater downside for equity markets as the mismatch is arguably larger. In light of this risk, we maintain our preference for bonds over equities. Our recommendations of high-quality and short-duration bonds also remain, as outlined in last month’s market outlook.
Fixed income has become increasingly attractive. After the jump in global policy rates last year, global bond yields have climbed to levels that were last seen during the global financial crisis. High-quality investment-grade bonds now offer a yield of about 3.54%, more than double the S&P 500 estimated dividend yield of 1.71% in 2023 (as of March 31, 2023). Across the board, yields have picked up substantially, providing investors with a real alternative to the stock market. Valuations of bonds have also become much more attractive compared to equities, as seen from the tightening spread between earnings and bond yields. The spread (implied payoff for picking equities over bonds) is now near decade lows. In other words, investors are now poorly compensated for taking on equity risk.
- The views expressed are of the research team and do not necessarily reflect the stand of the newspaper’s editorial board.
- This article first appeared in The Malaysian Reserve weekly print edition