Investment Comment
5th August 2022
Mixed messages
Sherlock Holmes’ The Sign of Four.
“When you have eliminated the impossible, whatever remains, however improbable, must be the truth?”
Despite the weaker than expected growth data from around the world economy, as it grapples with the impact of elevated inflation and therefore depressing spending power, equity and bond markets have rallied over the past six weeks. Since the June lows, global equity markets have climbed 10% in US Dollar terms. Depending on the choice of bond index, bonds have rallied between 7-10% over the same period.
The bond market is providing mixed messages. For those seeking confirmation that the economic slowdown is morphing into a US recession (a UK recession is very likely) then the rally in the government bond market confirms that story. If a recession arrives then the Federal Reserve will ease back, or even reverse, interest rate increases once inflation pressures ease. As a result, bond yields have fallen (and prices have risen) so the bad news in the economy is good news for bonds.
Conversely, high yield bonds are also rallying. In a recession, companies with elevated debt burdens and weaker balance sheets may become challenged and typically trade poorly. This drives up high yield bond yields even when government bond yields fall, a case of high yield bond spread widening. Therefore, given the apparent recessionary driver of lower government bond yields over the past six weeks, it is surprising that the high yield bond market has rallied over the same time period.
So maybe, as Sherlock Holmes would suggest, the impossible is happening in bond markets with favourable conclusions for bonds and equities. Are investors starting to see through the inflation of 2022 and envisage prospects for 2023 that offer a better mix of real economic growth and inflation, with more of the former and less of the latter? Time will tell if it’s as elementary as that.
Supply v Demand
One of the key metrics we track is the little-known Federal Reserve Senior Loan Officer Survey. Each quarter, the Federal Reserve releases a survey of the US lenders. In the Senior Loan Officer Survey (SLO), the lenders provide a guide to the lending conditions in the US economy. When conditions tighten, the survey typically foretells a slowing of the US economy. This week’s release shows a survey where lenders are starting to tighten supply of credit by raising underwriting standards whilst demand for borrowing remains robust.
Tighter lending conditions will prove a challenge for the US economy. When the SLO Standards index increases, when more stringent conditions on lending are put in place, then the rate of growth in employment, investment and profits slow. The SLO survey is a key indicator and confirms that we are in the late stage of the economic cycle. Given the backdrop of inflation and downbeat economic updates, the surprise from the Survey was the robust level of borrowing demand seen by lenders.
We’re ok, it’s everyone else that’s the problem
Chief Financial Officers (accountants), CFOs, have their own survey run by Duke University in the US. The most recent survey highlights that CFOs feel as downbeat about the economic outlook as they were in the midst of the Covid crisies in 2020. However, they feel relatively sanguine about their own company’s prospects. It strikes us that when people feel upbeat about their own state of the world but are worried about the world beyond, then sentiment about matters close to home, or business, may provide a better indicator.
UK rates, inflation and recession
The Bank of England raised interest rates by 0.5% to 1.75% this month. In the Bank’s outlook they forecast a recession of -2.1% of economic growth in coming months, which is a significant downgrade on their May expectations. Their inflation forecast is for inflation to peak at 13% in 2023 and linger around 9.5% through Q3 2023. There is little that the Bank can do to ease this inflation pressure as it comes from outside influences such as energy prices. Politicians, as seen in France, can choose to do something to ease the cost-of-living crises.
Rightmove suggest that first-time home buyers will see their mortgage payments (for those on variable rates) rise to £1,030 per month up 27% since the start of the year.
Gerard Lane Chief Investment Officer
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FP20220804001 EXP04/10/2022