BlueBay AM: Surprises ahead but a US recession shouldn’t be one

27 mei 2022

Please see below for the latest weekly insight from Mark Dowding, CIO of BlueBay Asset Management. In this edition, he looks at the housing market, and the economic outlooks for the US, the Eurozone, UK, and China.

Growth concerns continued to weigh on sentiment over the past week, in the wake of weak earnings updates in the consumer discretionary space. These came on top of further signs that economic confidence is continuing to slip in the face of higher prices and more restrictive policy. 

For sure, a cost-of-living squeeze is acting to constrain consumer spending, though in the US, robust income and employment growth (allied to strong consumer and business balance sheets) should help to cushion the impact of this to a much greater extent than is seen elsewhere.

Meanwhile, a sharp drop in US new home sales this week was seen as linked to a material decline in mortgage applications, following the rise in mortgage rates from 3.25% to 5.5% since the beginning of the year. However, we think that it would be wrong to become too bearish on housing.

In part, we think the sales data reflect a shortage of inventory and the decline in mortgage applications is exaggerated by a sudden stop in those looking to refinance their existing mortgages in order to lock in lower rates. House price and activity data from the National Association of House Builders remains robust, though it has come off recent highs. 

In this context, incoming information from interest rate-sensitive sectors of the economy is consistent with a slowing of growth from elevated levels, rather than a sudden lurch into recession. 

We continue to think that a US recession is more of a risk scenario than a central view and we attach a probability of such an outcome at around a third over the coming 18 months. Financial conditions have tightened materially over the past several months, yet remain close to their long-term average and would appear to be far from restrictive. 

Consequently, a moderation of activity is exactly what should be expected and the Fed is likely to welcome this. Policymakers will hope that some of the heat can be taken out of the labour market, alleviating recent upward pressure on earnings, which risks creating a secondary inflationary impact. 

Later today we will see PCE core inflation data. This is the Fed’s favoured measure of inflation and a move back below 5% will be welcomed, even though it seems like the FOMC will need to wait another 12 months before it’s back below 3% and they can back off from hiking rates further. 

Indeed, where we see recession risk, it is linked to inflation being more persistent and the Fed needing to take rates to 4% or beyond. We think that this would be sufficient to lead to a recession, as we believe the Fed will need to prioritise inflation over growth for the time being, as long as PCE core remains above 3%. The Fed is eager to restore price stability as quickly as possible, because the longer that prices are allowed to overshoot, so this will bleed into inflation expectations and it will subsequently become much more difficult to restore price stability.

Some have likened the Fed trying to bring inflation down without killing off growth akin to trying to land a jet on a small landing strip on a tiny island, proclaiming that policy tightening has often failed to achieve such a happy ending.

Is this conventional wisdom really correct? 

It is true that the monetary tightening cycle of 2004–2006 was followed by the Great Recession. However, policy tightening in 2016/18 and 2000/01 saw growth slow, but without a recession occurring as a result. Meanwhile, the last ‘aggressive’ period of monetary tightening in 1994, when the Fed hiked rates by 250bp during the year on a trajectory that may resemble 2022, also saw growth slow the following year without the onset of recession. 

From this point of view, recession calls may be overstated and it is important to differentiate between a slowing of activity compared to an outright recession. In the former, unemployment can rise and earnings can disappoint. 

However, it is in the latter when default rates can be expected to reach far more elevated levels. Moreover, if the Fed is trying to land the proverbial jet liner, we are also inclined to have a degree of faith in those currently sitting at the controls.

By contrast, we have less faith in the abilities of the ECB and we think that divergence across Europe could make it increasingly difficult to achieve consensus on the Governing Council, with the split between doves and hawks likely to increase through the course of the year as growth disappoints. 

Unlike the US, where the Fed is hiking in response to elevated prices at a time when the economy has been running pretty hot, in the EU, the ECB is faced with the need to hike with growth already turning weaker. US employment is well above 2019 levels, but this is not the case across Europe – though as energy prices feed into consumer prices, we think that a peak in eurozone inflation may still be a couple of months away – in contrast to the US, where prices appear to have already topped. 

In line with Lagarde’s comments, it now seems that ECB rates will reach 0% by the end of Q3, but it is less clear what happens thereafter. We remain nervous regarding possible fragmentation risk, though would highlight the silver lining in inflation is that this comes as a relative blessing in terms of lowering debt metrics for countries with high debt-to-GDP ratios. Meanwhile, fiscal easing may act to limit downside economic risks.

Consequently, the macro picture remains uncertain.

One thing that would rapidly change the outlook would be an end to war in Ukraine. However, this looks unlikely with a broad stalemate occurring, as both sides make incremental gains in different parts of Eastern Ukraine. Sadly, it seems that the war could drag on for many months or even years before a negotiated outcome is agreed, given growing sunk costs for both sides. Yet, there remains the possibility that Putin’s time in office could be cut short; we note that he went into hospital last week and was in a critical condition last weekend. 

Were Putin suddenly to be off the scene, it is not guaranteed that there would be an immediate ceasefire or an end to sanctions. However, financial markets would probably be quick to price moves in that direction and so, at a time when many investors are expressing cautious views and looking at downside risks, it is worth noting that the biggest shock could actually be a positive surprise.

Meanwhile, in China there seems little good news in sight for the economy. Incremental policy easing is unlikely to do much to boost growth until Xi abandons the zero-Covid strategy. It seems highly unlikely that this will occur before the Party Congress later this year. In many respects, it appears that China’s 2022 backdrop is worse than it was in 2020, and government policy is likely to continue to depress activity and lower trend growth. 

The backdrop in the UK also seems bleak. Sunak’s announcement of fiscal support for higher energy bills may do little to ease the pain currently being felt. Meanwhile, the rail workers union is the first of what may be many unions to announce strike action this summer, holding out for double-digit pay increases in the face of double-digit inflation. This comes at a time when the Bank of England and the government are pleading for pay restraint and for workers to meekly accept an erosion in their standard of living.

Coming in the wake of the Covid party-gate report, which showed how little respect the ruling class seem to have for the rest of society, it would appear this is going to be a very tough sell and a long and difficult summer lies ahead. 

As mentioned previously, we think that UK wage inflation will accelerate and inflation expectations continue to de-anchor. If we were to revisit the metaphor of the central bank trying to land a jet plane on a small runway, then it strikes us that the ‘helpless’ Bank of England has already given up, abandoned the cockpit and is now to be found somewhere towards the back of the plane.

Assessing these developments, our latest thinking has been to realise gains on long duration positions incepted some weeks ago, when we thought the rates sell-off had run too far and had become consensual. With the ‘herd’ now talking about US recession and Treasuries rallying, we think it will soon be time to move in the other direction and return to a short rates stance should 10-year yields continue to head towards 2.5%. 

We continue to run a short position on US dollar and favour the yen in anticipation that yield curve control will be questioned further in the weeks to come. However, it is not clear to us that we have seen the end of the secular supremacy of the US economy, and so we may choose to return to a longer dollar bias once more, if consensus long dollar positions start to reverse. We aren’t running much EU risk for now but continue to be bearish on all UK assets and the pound. 

Meanwhile, we are sticking with the view that we can add some selective exposure in credit, even as the outlook for stocks appears more challenged. In a growth slowdown – as opposed to a recession – we think credit may well outperform as an asset class and although there is a lot of volatility in the macro backdrop, we can identify assets where valuations now strike us as cheap relative to the medium-term fair value.

There continues to be plenty to write about and debate in assessing the macro outlook (I feel somewhat obliged to apologise for the length of this week’s macro comment). Due to the Jubilee holiday next week here in the UK, the next update will be in two weeks’ time, and plenty will surely have occurred in the interim!