Decision by Committee (January 12, 2023): Narrowing the duration gap Interest rates have moved markedly higher over the last 12 […]
- The global economy has shown unexpected resilience
- Both consumer spending and corporate profits have held up contributing to the economic resilience
- Market sentiment exhibits skepticism based on a fear of the impact of an aggressive global tightening policy, but such concerns have yet to fully play out
- Goods inflation pressures have abated considerably over the last year and it looks like they could well continue to moderate, albeit more modestly
- Service and shelter inflation provide an offset to falling goods inflation and are likely to keep central banks from pivoting soon
- Markets are better aligned with central bank guidance suggesting more modest rate volatility ahead
- Apart from global factors, domestic risks remain for the consumer and corporations to retract spending in the face of higher interest servicing costs
Fixed Income Strategy
- We anticipate the Bank of Canada (Bank) to maintain its hawkish bias until it assesses inflation is on a durable path to its 2% target
- Sticky inflation poses a risk for some further upside to front-end rates but, failing a negative economic shock, expect 10 year yields to tread water around the last year’s range
- If inflation continues to decline, the real policy rate will become more restrictive without any actions from the Bank, thereby limiting the need for further tightening
- The current curve inversion means the ultra-short segment of the yield curve provides the most attractive risk-return profile in the short-term
- Given the balance of risks, the belly of the curve looks attractive as it may benefit from policy normalization (i.e., there appears to be more scope for rates to decline over time than rise)
- We continue to believe high-quality credit, which offers a spread “cushion” that can offset small increases in yields, is likely to outperform
Rates in a holding pattern
While it is undeniably the case that the general mood in the market is less downbeat now than it has been in a while, sentiment continues to be restrained by significant concerns over the outlook.
Despite the global economy’s persistent resiliency and success in overcoming the numerous obstacles laid in its path over the last three years, the consensus among forecasters remains that a recession is the most likely outcome for the bulk of Developed Markets (DM) over the next year.
Recession risks remain
Consensus expected probability of recession in 12 months
Source: Guardian Capital based on data from Bloomberg to July 28, 2023
The continuous upgrades to the near-term outlook over the last nine months that have been necessitated by persistently stronger-than-anticipated activity, have just been treated as delaying an imminent downturn. The weakness has just been kicked out to the end of this year.
Kicking the can down the road
Consensus real GDP growth forecast, G7
Series labels represent the date of consensus forecast, Jul-23 is as at July 28, 2023; G7=Canada, France, Germany, Italy, Japan, UK and US; source: Guardian Capital based on data from Bloomberg
These doubts about the health of the global economy and the durability of the current expansion are being echoed in sentiment surveys.
Measures of consumer and business confidence across DM show scant signs of elation. The aggregated gauges of sentiment for the 38-member countries of the Organisation for Economic Co-operation and Development1 (OECD) are depressed and at levels consistent with past recessions.
Consumer & business sentiment, OECD
(index; long-term average=100)
Shaded regions represent periods of US recession; source Guardian Capital based on data from the OECD and Bloomberg to June 2023
Waiting for the other shoe to drop
The main source for this looming sense of dread (driving the broadly-held view that a downturn is coming) is monetary policy.
The long and variable lags between central bank decisions and their impact on the real economy make calibrating the broad-reaching policy difficult.
Accordingly, policymakers have poor track records for getting inflation under control without choking off broader economic growth. Almost every recession in the post-World War II era has the fingerprints of monetary policy all over it (the exogenous shock of the pandemic being one of the few exceptions.)
Combine that with the fact that this tightening cycle has seen policy rates rise faster and further than any in recent history — central banks may take them higher still as they are not yet willing to declare victory over inflation — and with an unparalleled unanimity across the globe, and the assumption is that something ultimately will have to give.
Higher, Further, Faster
Central bank policy interest rates
Shaded regions represent periods of US recession; dashed lines represent Bloomberg consensus forecasts as at July 28, 2023; source: Guardian Capital based on data from Bloomberg to July 28, 2023
The higher costs of carrying debt serve to restrain demand for credit, the lifeblood of the economy. At the same time, surveys indicate its supply is being constrained as lenders raise their standards for qualifying for loans in the name of protecting their books from the assumed looming downturn — the flare-up of financial system stress earlier this year also exacerbated concerns on this front as well.
Bank surveys in the US, Europe and Canada all point to a degree of tightening in standards that typically coincides with a recession.
Raising their standards
Balance of opinion on standards for business loans
(net percent of banks tightening versus easing)
Shaded regions represent periods of US recession; source: Guardian Capital based on data from the US Federal Reserve, European Central Bank and Bank of Canada to Q2 2023
Echoing this tightening of financial conditions, the yield curve — the gap between long-term and short-term market interest rates — remains deeply inverted or in negative territory.
Given that banks traditionally borrow in the short term to finance longer-term loans, the curve is treated as a leading indicator of credit availability. A yield curve inversion has historically been a harbinger of a recession within the next two years (it first turned negative a year ago).
Curve your enthusiasm
Government of Canada yield curves
Shaded region represents periods of US recession; source: Guardian Capital based on data from Bloomberg to July 28, 2023
Other than that, Mrs. Lincoln…
With all of this said, there are still reasons to believe that the proverbial “wall of worry” being built can continue to be scaled in the months ahead.
For starters, the fact that everybody is keenly aware of the risks to the outlook and proceeding with caution arguably lowers those risks — as well as the potential size of any fallout. The unexpected and inherently unpredictable shocks are the ones that tend to cause the most damage.
Secondly, aside from unexpected shocks (such as war, natural disasters, or a pandemic), economic downturns are the product of systemic imbalances.
These excesses arise from misallocations of capital during periods of ample liquidity and can persist until there is a reason for positions to unwind. Typically, it is a central-bank-induced jump in costs of capital that makes overextended financial positions untenable, with the larger the imbalance, the greater the unwind and resultant negative spillovers.
The persistent uncertainty over the economic outlook over the last three years has undoubtedly factored into preventing significant financial imbalances from developing simply because the constraints on activity limited the ability and willingness of households and businesses in the aggregate to overextend themselves.
The resultant underlying strength of consumer and corporate finances appears to be a reason behind the fairly limited fallout so far from the most aggressive tightening cycle in decades. There are no indications yet that of widespread difficulties in meeting financial obligations.
For businesses, the improved profitability and efforts over the last decade to take advantage of positive financing conditions to improve balance sheets have resulted in corporate finances being in good shape, with low leverage, extended maturities of debt and high-interest coverage providing flexibility to weather the challenges of the past three years.
This is a key reason why the surge in market interest rates over the last year has not caused material distress in credit markets as yet. Corporate bond default rates remain muted and credit spreads, while above recent lows, are not insinuating that the credit cycle will soon take a harsh turn.
High Yield bond par-weighted default rate & credit spreads
(percent) (basis points) (percent) (basis points)
Shaded regions represent periods of US recession; source: Guardian Capital based on data from Bank of America Merrill Lynch to June 2023
On the consumer side, by some measures households now are the least debt-reliant in generations (more so in the US than Canada), while aggregate wealth is back within arms’ reach of all-time highs even with last year’s weakness in financial markets and the slump in housing prices.
Add to that the fact that consumers continue to sit on a pandemic-driven excess of savings — the US is the only G7 economy that has seen much of a drawdown to date, supporting better relative performance, but the well has not run dry.
Accordingly, households are still in good shape. Loan delinquencies remain benign, and while they are inching higher for credit cards, they remain at levels that are still below pre-pandemic norms.
Staying On Top Of Payments
Delinquent consumer loans at chartered banks, Canada
(percent of outstanding loans)
Shaded regions represent periods of US recession; source: Guardian Capital based on data from the Bloomberg and the Canadian Bankers’ Association to May 2023
This may well change in the coming years as ultra-low interest rate pandemic-era mortgages come up for renewal at higher costs. As of yet, however, there are limited signs of an impending wave of financially strapped homeowners being forced to put their homes on the market — and this lack of supply is putting a floor in the market and setting up the potential for a notable turnaround should buyers be coaxed back in by improved affordability.
Not For Sale
Supply Existing Single-Family Homes for Sale, Canada
(months to clear inventory at current sales rates)
Source: Guardian Capital based on data from the Canadian Real Estate Association to June 2023
On that score, the prospect of further aggressive increases in interest rates looks to be limited as the major driver of policy concern appears to be abating.
High inflation, particularly on necessities such as food and energy, is a big headwind for activity as it means that consumers have to spend more on less.
And while rates of inflation remain above central banks’ comfort levels, the moderating trends are anticipated to be sustained in the months ahead.
The peak is in the past
Consumer price index2
(year-over-year percent change)
Shaded regions represent periods of US recession; dashed lines represent consensus forecasts as at July 28, 2023; source: Guardian Capital based on data from Bloomberg to June 2023
Looking at overall price gauges, the reversal of last year’s Russian-invasion-driven surge in agricultural and energy commodities has played a significant role in bringing inflation rates down to earth.
Commodity prices in the aggregate are 20% below year-ago levels, and barring a material shift higher in the coming months, will continue to exert downward pressure on inflation rates in the coming months.
No longer a hot commodity
S&P/Goldman Sachs spot commodity price index3
(year-over-year percent change)
Shaded regions represent periods of US recession; source: Guardian Capital based on data from Bloomberg to June 2023
As well, while they may have proven to be less “transitory” than assumed, the pandemic-driven upward pressures on prices throughout supply chains are fading quickly.
Port congestion has been alleviated, order backlogs caught up, inventories replenished, and transportation and shipping costs have come back down to earth.
Aggregated gauges of supply-side pressures have returned to pre-pandemic levels.
Supply chain pressure index4, world
(standard deviations from the average)
Shaded regions represent periods of US recession; source: Guardian Capital based on data from New York Federal Reserve Bank to March 2023
Against these positive developments, indicators of price pressures in the production pipeline have plunged worldwide — China, which is often the first step in the value chain, has seen producer prices decline particularly sharply relative to last year.
Plunging pipeline price pressure
Producer price index5
(year-over-year percent change)
Shaded regions represent periods of US recession; source: Guardian Capital based on data from Bloomberg to June 2023
Add in the housing price drop — which only gets reflected in consumer price metrics with a sizable lag — and underlying inflation looks like they could well continue to moderate to more palatable, though likely still relatively elevated, levels by year-end.
CPI shelter & national house prices6, Canada
(year-over-year percent change)
Shaded regions represent periods of US recession; source: Guardian Capital based on data from Bloomberg and the OECD to Q2 202
That said, any renewed verve in economic activity, particularly in services and housing, could have the impact of providing some offset to this desired progress — and the risk here is likely to keep central banks from pivoting soon.
The going rate
The gap between the central bank guidance and financial market expectations has narrowed considerably over the last three months as concerns over a potential banking crisis came and went, and the left tails of the growth distribution got trimmed, that is, growth expectations were revised upwards.
The net result has been a general upward shift in market yields across the curve back toward the higher end of the ranges that have prevailed over the last year — notably for investors, though, the higher coupon to clip now has cushioned the impact.
There remains potential for some further upside pressure on rates, particularly at the front end of the curve, should central banks follow through with their more hawkish guidance — for example, the market is not convinced that the US Federal Reserve will add the further 25 basis points its June Summary of Economic Projections7 indicated.
With that said, there is little expectation rates will break out of their recent comfort zone. The consensus remains that 10-year sovereign yields will continue to effectively tread water for the foreseeable future around the last year’s ranges.
Rates remain rangebound
10-year sovereign bond yields & forecasts
Source: Guardian Capital based on data from Bloomberg to July 28, 2023; dashed lines represent Bloomberg consensus forecasts as at July 28, 2023
A less volatile rate environment, combined with a continued moderate pace of economic expansion supporting earnings, easing inflation and limited further upside from central banks, would suggest that returns for bondholders in the near term are likely to echo their yields, which offer the best return prospects in over a decade — high-grade credit is particularly compelling in this regard, as are highly liquid and short-term Treasury bills that offer a notable premium given the shape of the curve.
ICE Bank of America bond index yields8, Canada
Shaded regions represent periods of US recession; source: Guardian Capital based on data from Bloomberg to July 28, 2023
Further, the now higher rates available on longer duration debt also provides opportunities from a risk management perspective for balanced portfolios as it increases their value as a diversifier.
The yield provides decent return prospects with limited valuation risk (i.e. there appears to be more scope for rates to decline over time than to rise further) while they also provide insurance against a marked deterioration in conditions that precipitates the pricing in of rate cuts, suggesting that the breakdown of the historically strong positive correlations between stocks and bonds seen last year should continue.
Finally breaking away
Stock* and bond** correlation, Global
(rolling 26-week correlation of returns)
*Stocks=MSCI World Index9; **bonds=Bloomberg Global Aggregate Inde10,shaded regions represent periods of US recession; source: Guardian Capital based on data from Bloomberg to July 14, 2023
Scaling the wall of worry
The global economy and financial markets have performed better than anticipated this year.
Rather than this underpinning a marked rise in optimism, however, focus remains on the downside risks to the outlook that keep the spectre of an economic downswing and consequent reversal of market momentum looming over the horizon.
While these risks clearly cannot be dismissed, it remains the case that the foundations that have underpinned growth over the last three years largely remain intact while the headwind of higher cost pressures is increasingly ebbing — which stands to ease pressure on policymakers to take interest rates higher — setting up the prospect of the global economy again surprising those waiting for the other shoe to drop.
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Published: August, 2023