The latest market moves might seem puzzling for those who do not work in fixed income markets. The latest news might seem contradictory: the latest CPI print remains stubbornly high, at 8.5%, and the most recent US jobs number was a huge positive surprise. On the other hand, economic data continues to deteriorate, with consumer sentiment declining and commodity prices rolling over. Market moves have also been contradictory: we have seen a very strong recent bounce in equity and credit markets, but government bond yields are pointing to slower growth.
Consumers are starting to shift their outlook, with long-run inflation expectations tracked by the University of Michigan consumer survey falling from 3.1% to 2.8%. A decrease of 0.3% might seem small, but in the history of the survey (running since the late 1970s), it is in the 96 th percentile of one-month negative revisions.
Supply and demand shocks
We believe that what markets and consumers are quickly starting to price in for inflation makes perfect sense. We think inflation worries may well be a thing of the past.
The current inflationary episode started as a combination of supply and demand shocks. Consumer goods were the first engine as Covid restrictions changed consumption patterns in an already complex environment for supply chains. We now see significant reduction in supply chain issues, with the Supply Chain Pressures Indexoff around 45% from its December ’21 peak. Demand for consumer goods also starts to look shakier with the erosion of purchasing power from consumers and the build-up in inventories (flagged by many businesses) pointing towards the demand peak being well behind us.
The investor Michael Burry (The Big Short) has recently come under the spotlight in tweets where he highlighted the potential for goods disinflation and the “bullwhip effect,” whereby small fluctuations in retail demand cause bigger changes at the wholesale and manufacturing levels. We have been calling for goods disinflation for a long time, and we see a simple explanation for this: consumers have bought too much stuff!
Then came the conflict in Ukraine, and commodity prices shot up, causing inflation. While war uncertainty continues, prices for most commodities are now experiencing significant declines: Industrial metals are down around 40% from their peak, agricultural commodities -19% and energy -18%. This substantial decrease in commodity prices will gradually feed through to CPI numbers.
Finally, the latest wave of inflation came from services and especially from the shelter/housing component of the CPI. The increase we have seen in rents in the US is the consequence of a long-running red-hot property market, and it is a structurally lagging indicator, given rents are usually contracted every 12 months and the nuances in the Owner Equivalents Rent computation. Things might be more complex for housing going forward. Higher mortgage rates (now around 5.75% as tracked by the Mortgage Bankers Association) have brought down housing affordability and new mortgage applications. This will have a consequence on housing demand, and while inventory for new houses is still relatively constrained, the number of single-family homes in the US currently under construction is the highest since 2006.
Ultimately and unfortunately, however, the best possible medicine for high inflation is usually an old-fashioned recession. A huge decline in real incomes, tighter financial conditions and a negative wealth effect are point to a significant slowdown. What has changed is market consensus and the Fed stance towards a recession. What had been described as a possibility is now slowly becoming the base case. On a merely technical standpoint, Europe and even the US may well already be in a recession.
The market quickly adjusted to the new consensus view, with a strong inversion in the 2y10y segment of the US Treasuries yield curve and with Fed Funds Futures pricing rates peaking at 3.5% by the end of this year and decreasing in the second half of ’23. Historically, and especially in recent years, Fed pivots have been even more abrupt and sharper than this. As the inflation genie goes back into the bottle, the specter of recession will probably become the next focus of the Fed.
Keep it simple
How should fixed income investors deal with all of this? We would argue that keeping things simple might be best. With an upcoming recession and no material change in secular demographics and technological trends, government bond yields (especially in the US, Australia, South Korea and New Zealand) look attractive both on a total return and from a hedging perspective. The slowdown narrative has influenced credit markets as well, which are still relatively cheap even after the recent bounce. While investment grade and high yield credit spreads, as tracked by broad indices, are still below recessionary averages, we have been seeing more value in the BBB and BB rated space lately — especially in dislocated sectors such as Real Estate. We believe that as things turn more complex for the global economy, differentiation between high quality and more uncertain business models will be crucial.
Despite the uncertain outlook for global growth, it is an exciting time to be a fixed income investor, with yields back at levels not seen in more than a decade.