LQDB - Markets Now Accept Rate Cuts Unlikely

2023-05-30 11:35:00 ET

Summary

• Inflation has proven sticky, even as growth weakens. Markets are realizing that policy rates are set to stay higher for longer. We like quality in stocks and bonds.
• Tech stocks surged further last week even as debt ceiling talks spurred bouts of volatility. Long-term bond yields climbed on still-hot U.S. inflation in April.
• U.S. jobs data this week should show a tight labor market is keeping wage pressures elevated. We think that keeps inflation sticky and above policy targets.

Transcript

Growth in developed markets is already weakening, and yet inflation remains stubbornly high. Even as the U.S. debt ceiling is in focus, markets are getting to grips with the implications: Central banks are set to keep interest rates higher - and for longer.

1) Economic drags

Data last week showed Germany is already in recession, and on some measures U.S. activity too has contracted over the past six months.

2) Persistent inflation

Yet, labor markets remain tight even as overall activity softens. That’s keeping wage pressures elevated and making overall inflation stubbornly high, in Europe, the UK and the U.S.

We see central banks staying with higher policy rates for longer as a result, with rate cuts this year unlikely.

3) Markets starting to reflect this?

Markets are adjusting to this. Expectations of Fed rate cuts in the U.S. have dwindled. And markets are pricing in more hikes in Europe.

And stripping out mega-cap tech names, U.S. equities are actually down on the year.

We turn to high-quality income in the short term.

We close the underweight on UK gilts as yields climb back to near the levels reached during last September’s turmoil.

We stay cautious on risk assets. And we like inflation-linked bonds as inflation proves persistent.

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We’ve been saying since the end of 2022 that rate cuts this year would be unlikely as inflation sticks around. Markets are waking up to our view, as a look under the hood reveals signs of weaker growth in major economies and market weakness due to rate hikes. Debt ceiling talks and the U.S. Treasury potentially being unable to pay its bills by early June have added to recent market volatility. We like quality in portfolios. We upgrade UK gilts to neutral as yields price in more rate hikes.

A big divergence

Notes: The chart shows the price index change for the S&P 500 Composite Index (market capitalization-weighted) and S&P 500 Equal-Weighted Index since the start of 2023 through May 25, 2023.

Stubbornly high inflation has prompted the Fed’s fastest rate hike campaign since the 1980s. Markets are no longer pricing in repeated Fed rate cuts - a sign they’re grasping inflation’s persistence, in our view. And the full effect of central banks’ rate hikes is kicking in. Data last week showed Germany has entered recession even with a smaller-than-feared energy shock. In the U.S., GDP has held up, but it has arguably entered recession based on gross domestic income, which assesses the economy’s performance on an income rather than spending basis. A deeper look reveals stocks reflect worsening growth: the S&P 500 index was up nearly 10% so far this year (dark orange line in the chart). But a few large technology firms valued above $200 billion are driving those gains as they benefit from Artificial Intelligence buzz. Applying equal weighting to all companies in the index regardless of size shows it’s down over 1% this year (yellow line) - extending 2022’s hefty losses.

What's ahead for central banks

Inflation and wage growth remain sticky, even with this deteriorating growth picture. Why? U.S. consumer spending’s shift back to services from goods caused core inflation to fall at first. Yet, labor constraints persist, with unemployment still near historic lows. We think tight labor markets are keeping wage gains high, making overall inflation stubborn. April PCE inflation data out last week confirmed that. Inflation is running even hotter in Europe, especially the UK. Central banks face a clear trade-off, in our view: crush activity to ease labor constraints and curb inflation, or live with some above-target inflation.

We see the Fed nearing a pause in rate hikes and living with some inflation to avoid the deep recession needed to get inflation near its target. But we don’t see the Fed coming to the rescue of a faltering economy with rate cuts later this year, due to the sharp trade-off between inflation and growth. Markets are coming around to our long-held view after having until recently priced in repeated rate cuts in 2023. We think the European Central Bank will hike more, regardless of the economic damage. The Bank of England (BOE) is in a similar position. Markets have priced in as many as four more BOE hikes. We think that might be a bit overdone, as it would be equivalent to the Fed hiking to around 7-7.5% - enough to trigger a severe recession.

We have a relative preference for UK gilts given this outlook. We close our previous underweight on UK gilts as yields return near levels reached during last September’s turmoil. We favor quality in our portfolio. We’re neutral investment-grade credit and think yields above 5% compensate for wider spreads due to any downturn. We’re overweight emerging market ((EM)) local currency debt given peaking EM rates and a broadly weaker U.S. dollar. We also look for quality in equities, with a preference for companies that are able to grow their earnings and wield pricing power to pass on higher costs.

Cushioning portfolios from inflation is also key. We like inflation-linked bonds as markets underestimate the persistence of U.S. inflation but better appreciate it in Europe, we think. On a strategic horizon of five years or more, we lean into real assets that can buffer inflation, like infrastructure and industrial properties. Strategically, we see returns for developed market ((DM)) stocks above bonds’ as growth returns and inflation lingers in the U.S. DM stocks look riskier to us in the near term than fixed income given current yields. Debt ceiling concerns have upped market volatility, but we see the growth-inflation trade-off as a bigger driver of volatility longer term. We prefer EM stocks, as they better price in the damage, yet China’s growth stalling would pose risks.

Our bottom line

Markets are reassessing policy rate expectations as sticky inflation makes clear central banks won’t cut them this year - or will keep hiking. We turn to high-quality sources of income in the short term and stay cautious on risk assets.

Market backdrop

Major tech stocks surged further last week, leading U.S. stocks slightly higher - even as the U.S. potentially facing a technical default dominated market attention. Meanwhile, long-term Treasury yields climbed after data showed that April U.S. PCE inflation remained hot. A credit rating agency warning it could downgrade the top-notch Treasuries rating if the U.S. defaults reinforces our view investors will demand more compensation for holding long-term bonds given higher policy rates.

We’re watching key inflation and labor market data in developed markets this week. We see wage pressures from a tight labor market in the U.S. and euro area keeping core inflation above policy targets for some time. We expect some easing of labor market tightness as the lagged effect of rate hikes by major central banks starts to hit economic activity.

This post originally appeared on the iShares Market Insights.

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