Markets send mixed economic signals – and open the door for active bond investors
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Text on screen: Erin Browne, Portfolio Manager, Multi-Asset Strategies
Browne: As the Fed continues to raise rates to combat inflation, many investors are focused on the possibility that the economy could dip into a recession. Naturally, many are wondering how any economic weakness or uncertainty may impact their investments.
With the Fed now close to neutral, we think that restrictive monetary policy is clearly appropriate and we think that the Fed will continue to tighten rates to bring inflation under control.
While we don’t think the US is already in a recession, we do think it’s quite likely that we will ultimately see a US recession.
Economic activity has already meaningfully slowed, as we’ve seen in PMIs, slower spending, and higher claims.
We think that high inflation, reduced fiscal stimulus, and tighter financial conditions will continue to weigh on consumption and investment from here, and that should ultimately also spill over into the labor market.
So what does this mean for different asset classes?
Well right now the equity and bond markets are sending very different signals. While implied pricing underlying equities is still suggesting that we are in a late cycle environment based on forward earnings and valuations, bonds are telling a different story and are suggesting that we’re further advanced in the cycle and anticipating a more significant slowdown to economic activity.
Front-end rates have priced in cuts for 2023, which typically actually happens during recessions.
And equities haven't yet priced in real multiple compression that would occur during recessions, and the equity risk premium is in line with history. Also when you look at longer-term implied volatilities underlining equities and put prices, they yet aren't at recessionary highs.
With the repricing that we’ve seen in valuations this year, particularly across fixed income markets, we see a much richer opportunity set of alpha opportunities particularly for active managers. Within duration, for long term investors we think that duration looks attractive particularly held against risk portfolios.
And across broader fixed income, given the spread widening that we’ve seen year-to-date, we are starting to see real attractive opportunities emerge across IG corporates and up in coupon agency mortgages which look very cheap vs. historical levels. However I must note that going forward, sector selection will be key.
In summary, given the growth and inflation dynamics that have unfolded over the course of this year, we think that the Fed is likely to have to continue to raise rates into restrictive territory. Which ultimately will lead to an economic slow-down. As a result of that, while we remain underweight within equities across our portfolios, we’re starting to see real opportunities emerge across fixed income.
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