Triumph of the Optimists?

by Katie Nixon, CFA, CPWA®, CIMA®, Chief Investment Officer, Northern Trust Wealth Management

Despite being the height of back to school and the tail end of summer vacation season, investors were on high alert this week with markets gyrating across asset classes, and around the world. Holiday-light trading likely drove some of the volatility, however there are some fundamental drivers that are well worth watching.

Please note The Weekly Five will take a break for the next two weeks. Look for a new article on Sept. 8.

Where are the bond vigilantes? (Hint: It’s not at the beach.)

Ed Yardeni coined the term “bond vigilante” in the 1980s to describe U.S. Treasury investors who sold securities, driving interest rates and government borrowing costs up, in an overt effort to acknowledge a deterioration in monetary and fiscal policy and to send a warning signal to policy makers.

So far, during this Federal Reserve-led rise in interest rates across the curve, it was the short end of the curve that reflected fears of overtightening, and this resulted in short-term interest rates rising at a faster clip than longer-term rates. This has led to the yield curve — the difference between shorter- and longer-term Treasury yields — to invert as short rates are higher than longer-term yields.

At one point in early July of this year, the difference between the yield on the two- and 10-year Treasury was -1.07%, its widest inversion since early 1980. In the past few weeks, however, the bond vigilantes have set their sights on the longer end of the Treasury curve, sending 10-year yields rising at a much faster clip that shorter-dated Treasury notes. The 10-year yield has risen a full 0.25% just this month, and nearly 0.15% this week alone.

At the same time the two-year yield has barely budged. The increase in the longer-dated Treasury yields is NOT a reflection of inflation concerns as inflation expectations have remained very well anchored. The change in monetary policy in Japan may be sapping some demand at the margin. Bond investors are sending a clear message to the market: The significant increase in issuance driven by the replenishing of the Treasury General Account has created excess supply of Treasuries, plus, the gaping federal budget deficit is a concern, given that the economy is in relatively good shape — it is very unusual to run large deficits outside of recessions.

What has changed in Jackson Hole since last summer?

A year ago, Fed Chair Jerome Powell warned of upcoming economic pain, a result of aggressive monetary policy tightening but a necessity if we were to get the inflation genie back in her bottle. Subsequent to that economic confab, the Federal Open Market Committee raised the federal funds rate several more times to the current 5.25%-5.50%. Powell will return to the Grand Tetons next week for the central bankers meeting hosted by the Kansas City Fed, where he is expected to provide clarity on his latest views on the economy and the path of interest rates. Perhaps.

The theme of the conference this year is “Structural Shifts in the Global Economy” and there are some who expect Powell to begin to drop some breadcrumbs of a new policy framework, perhaps one where the inflation target remains at 2% but the tolerance around that target is increased. Unlikely.

We anticipate more of the same messaging from Powell: that the economy has been far more resilient than he or others on the FOMC anticipated; that the Fed underestimated the timing of the long and variable lags between tighter policy and economic impact; that the labor market remains tight despite tighter monetary policy; and that inflation continues to hold risk to the upside and more policy work is necessary to ensure it will fall further and remain low.

As we have noted previously, the Fed, and investors, will soon pivot from a focus on how high the policy rate will go to a concern about how long they will stay at that level — and what the implications are for a “higher for longer” scenario. In our view, Powell will want to stay on message, and will try to push back against a growing market consensus that rate cuts are on the 2024 horizon.

Is it time to celebrate the economic optimists?

Recent economic data has given even more credence to those who forecast continued economic growth in the U.S., and has even moved some away from the “soft economic landing” perspective to a growing assumption that the economy won’t slow down meaningfully.

Looking at some of the data, the optimism is understandable. Upside surprises to retail sales, a downside surprise in weekly unemployment claims and the better-than-expected Philadelphia Fed survey have encouraged economists to increase the third-quarter forecast for economic growth. Despite the obvious headwinds, the U.S. consumer continues to spend — full employment and strong real wage growth, healthy household balance sheets and some remaining excess savings have combined to support robust demand, particularly in the services sector.

At the same time, we are starting to see some fraying around the edges of discretionary spending, and we heard as much from some of the airlines who are forecasting weaker bookings into year-end 2023. We also believe that the long and variable lags will in fact show up eventually — perhaps not enough to drive a recession, but enough to slow the economy down from this pace. Next, many of the indicators noted by the economic bulls are lagging or coincident indicators: They tell us what we saw, or what we are seeing, but not what we will see. Leading economic indicators still point to weakness ahead. And last, the recent significant spike in longer-term interest rates will have an impact just at the time when lending conditions are already tight — funding will be difficult to access, and will be expensive. Although we agree that a recession can be avoided, we are less constructive on the growth outlook.

How are China’s recent economic struggles revealing themselves across markets?

The macroeconomic data out of China continues to suggest a much weaker growth outlook, even against muted expectations. China appears to be in a balance sheet recession driven by overinvestment in the property sector creating a heavy debt burden, particularly at the local government level. Unfortunately, in a case of perfect bad timing, this is all occurring during a period of “de-globalization,” where companies are moving away from a reliance on China.

This is clearest when assessing foreign direct investment data, particularly the direct investment liabilities, which have fallen 87% from a year ago to just $4.9 billion — the lowest since 1998.

The policy response thus far has been both tepid and misdirected. Despite the mounting evidence of a significant economic slowdown and obviously mounting problems in the property sector, the Chinese central bank has only recently applied more stimulus in the form of a cut to a key policy rate. Cutting interest rates alone in a balance sheet recession is insufficient relative to a broader policy response that incudes fiscal stimulus.

The problem is that debt levels are already high. Further, there is a price to pay for lowering rates, effectively de-coupling from other major central banks that are still in the process of tightening. The release valve is through the currency markets: The Chinese yuan has fallen precipitously to its weakest level against the dollar since 2007, forcing the Chinese central bank to intervene. The difficult environment has led some to worry about the “Japanification” of China, reflecting on the extremely long period of economic malaise and disinflation experienced in the period since the early 1990s and driven by some of the same elements we see in the Chinese economy: real estate bubbles, heavy debt burdens, and an aging population.

Is this week’s downturn a sign that I should make a move in my portfolio?

Markets can and will be volatile and that there are periods — sometimes relatively lengthy — where investors receive negative returns. Rather than trying to predict how the market is going to behave, investors are better advised to have a plan to accommodate market volatility. Sticking with your long-term investment strategy is always the best course, but it can be tempting to sell equities as prices fall and wait for the storm clouds to clear.

Decades of stock market research reveal the steep cost to portfolios of missing the biggest up days, which tend to cluster around the strongest downdrafts. A better, and ultimately more successful, approach is to focus on aligning the risk in your portfolio to your unique financial goals. In the face of inevitable periods of negative market returns and heightened market volatility, control what you can: tax and fee efficiency, diversification and alignment with your goals.



Copyright © Northern Trust Wealth Management

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