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Q1 2023 Cash Outlook – Bumping into Furniture

We review recent structural trends, survey cyclical indicators as an economic cycle gauge and evaluate tactical opportunities that might be advantageous to short-term fixed income strategies.

Structural Trends

They remain intact for the most part. The world is getting older, particularly in advanced economies, and birth rates in those economies are on the decline, in some cases dramatically. With the potential for a shrinking labor force, one would expect that trend growth to slow. The COVID-19 pandemic upset economic equilibrium, causing US gross domestic product (GDP) to plummet and then surge as the economy all but closed and subsequently reopened. The readings have moderated as we have come back to "normal," and over the longer term, we expect US GDP to continue to gravitate toward 2%.

Inflation pressures will recede and trend back toward target—again—as the post-COVID-19 surge subsides. It is not to say we will be sub-2% as was the case over the previous decade, but overall we should get closer to the 2% Fed target. Our economics team forecasts real GDP at 0.9% for 2023 and 0.7% for 2024 with inflation forecasted at 4.0% and 2.2%, respectively ("Global Macro Quarterly," March 2023).

Cyclical Trends

Factors in an economic cycle have leading and lagging indicators. Typically, leading indicators are rates, commodities and the dollar. These are followed by interest-rate-sensitive sectors (i.e., real estate), demand for durable goods, and services and production indicators. Lastly, lagging the most, there follows overall growth (GDP), unemployment and prices (inflation).

In this current cycle, 10-year yields moved higher at the beginning of 2021. Markets were anticipating the emergence from the economic constraints of COVID-19 lockdown and the subsequent pricing pressures. This trend continued into late 2021, as most recognized that the US Federal Reserve (Fed) was behind on what needed to be done to tame pricing pressures. In the short term, Treasury yields moved higher than longer-term yields, leading to a significant inversion of the yield curve and the possibility of a shorter cycle (peak policy rate to the beginning of policy easing). Additionally, commodity pricing spiked with the outbreak of war in Europe, challenging business continuity in the region.

As the Fed began one of its most aggressive policy hiking period in decades, interest-rate-sensitive sectors began to contract. Both residential and commercial real estate market activity slowed almost to a standstill during parts of 2022 and 30-year mortgage rates stood 4% higher than their 2021 lows.

A slowdown in demand for durable goods emerged as post-COVID-19 buying patterns waned, but we are still waiting for a slowdown in the service sector and industrial production. Ultimately, we should see an uptick in the unemployment rate and a decline in inflation prints. These indicators will be a clear signal to the Fed that its policy hikes have had the desired effect.

Factors in an Economic Cycle – Leading to Lagging

  1. Leading indicators: Rates, commodities, the dollar
  2. Interest-rate-sensitive sectors, housing activity, autos sales
  3. Durable goods (i.e., appliances, furniture)
  4. Services, Purchasing Mangers’ Index (PMI), industrial production
  5. GDP
  6. Unemployment, prices (inflation)

Cyclical Trends Favor Duration

Prior to the banking crisis, the cyclical trends favored adding duration and reducing credit exposures. As one would expect in a market slowdown, there will be a point where the Fed would have met its objective. The Fed has successfully created demand destruction and slowed the economy, thus slowing persistent inflation pressures. Although this positioning was unnerving through the month of February as yields moved higher, the overall cycle trend remained intact.

Market Is Still Fragile

As should be expected, the Fed’s policy action has put a strain on both lenders and borrowers. What might “break” under the weight of 475 bp of rate hikes? Here are a few things we look for: what is new, what has grown quickly and what is highly levered. In this cycle, crypto, meme stocks and SPACs were “new” and they also grew exponentially. Most of that story has been told. With the crisis of confidence in the banking sector, the failure of three major US banks and the forced merger of Credit Suisse with UBS behind us, we may focus on a sector that is highly leveraged and dependent on bank financing: real estate.

What to Look for When Looking for Breakage?

  1. What is new (crypto, meme stocks, SPACs)
  2. What has grown fast (crypto, meme stocks, SPACs, private markets)
  3. What is highly leveraged (crypto, private markets, real estate)

Is There a Direct Strategy Response to the Bank Failures?

We continue to evaluate opportunities, but, generally speaking, we are focused on the cycle trend: rate risk vs. credit risk. We have often described the current cycle as “bumping into furniture.” The Fed has just stubbed its toe. It hurt and it jumped around a lot, but the toe does not appear to be broken. In an effort to “heal the toe,” it took considerable action and injected over USD 400 bn of liquidity (discount window and the Bank Term Funding Program). The home loan banking system also stepped in to provide over USD 300 bn of liquidity to the banks. At the time of this writing, it appears as though the crisis in the banking sector has stabilized. However, the Fed’s 475 bp of rate hikes over the past 12 months will most likely lead to another bump, perhaps a more damaging bump.

We like our positioning and did not make any major changes throughout the banking crisis. Our dedicated credit research team has kept us out of trouble—those banks involved in the crisis never saw our approved list. Furthermore, our conservative positioning has allowed us to invest in some sectors that have looked cheap over the past month, specifically some of the larger banks, and we continue to evaluate this sector looking for additional opportunities.

What Else Stands Out?

Global central banks took, in some cases, enormous measures to stabilize liquidity across the banking sector. The majority then proceeded to hike interest rates. If you think about this in the context of a banking crisis, these are conflicting actions. Was this a signal that the banking crisis has been contained?

Is the Fed Done Hiking Rates?

The Fed is getting close, but of course it is very data-dependent. If the Fed sees inflation pressures persisting, it will continue to hike its policy rate. But given what it has already done and said, we think it is close to a pause. The Fed’s policy moves have been swift and aggressive. Given it typically takes 12 to 24 months to feel the full effect of a policy rate adjustment, it would make sense for the Fed to pause and see what the ultimate impact its rate hikes have had on the broader economy.

Impact on Short-duration and Ultra-short-duration Strategies

Over the next six to twelve months, we expect the direction to be as follows: lower growth, lower inflation and a higher probability of recession. The next steps are to map pricing into that context.

In terms of short-term strategies, we are trying to balance duration risk and credit risk. What looks rich and what looks cheap in our long-term fair value framework? Right now, duration looks cheap and we favor adding some additional risk from that perspective. Credit looks fair and thus we will continue to be patient when evaluating opportunities. The yield curve, although not applicable to short-term strategies, does look rich and is pricing in a much higher likelihood of recession. The 3-month 10-year curve (3M 10Y), at the time of this writing, is negative ~140 bp. Historically, a level below zero has indicated a recession is on the horizon.

Figure 3: Yield Curve and Recessions

Figure 3: Yield Curve and Recessions

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