07 Mar 2023
Debbie King, Investment Manager
We have previously commented on the inversion of the US Treasury yield curve and that every recession over the past 70 years or so has followed a sustained inversion, although there is typically a lag between inversion and recession of approximately one to two years (see chart below).
Yield Curve Inversions and Recessions
Source: Federal Reserve Bank of St.Louis
To combat persistently high inflation, the US Federal Reserve began to hike rates aggressively in March 2022; the latest 25 basis point increase contributed to a total tightening of 450 basis points in just 10 months. An inflationary slowdown is the goal − a Central Bank-induced recession if you may, with a ‘soft landing’ the goldilocks scenario.
Of course, an inverted yield curve does not always foretell recession. Indeed, we are sympathetic to the argument that “this time it really is different” owing to the unique inflationary circumstances induced by the Covid-19 pandemic. Inflation is good for the top line and as such, nominal GDP has not collapsed. Corporate results have been resilient in the face of the fastest tightening cycle in more than four decades. The credibility of Central Bank action has suppressed inflation panic and long-term inflation survey data has never broken above the 3% level. Furthermore, several months of supportive US CPI readings that have surprised to the downside are now boosting the peak inflation narrative. Who can blame investors, battered and bloodied from the carnage of 2022, for pouncing on these bright spots and believing the rally?
But is it too good to be true?
The macroeconomic outlook remains problematic; despite growing expectations of a pause in the hiking cycle, Central Banks’ resolve to fight inflation at all costs looks undimmed. That will weigh on growth and opposing Central Banks typically does not end well for investors. Additionally, Central Banks are also embarking on a diet of quantitative tightening as they look to tighten their balance sheet belts after too many years of loose monetary policy.
Recent commentary from Powell, Lagarde and Bailey, each optimistic that the corner has been turned on inflation, has boosted sentiment but it’s goods deflation that is causing the fall. The more persistent pressure of wages, which in turn feeds through to stickier services inflation, remains heightened. Very few called inflation correctly on the way up; how it recedes may be equally uncertain. The Central Bank trajectory remains unclear and will be sensitive to incoming data.
Monetary policy – the blunt truth
Unfortunately, Central Banks are attempting to control inflation with a monetary policy tool that can’t address its root causes. It is a blunt instrument with a time-delayed impact in the real economy, so we expect restrictive real policy rates to hamper economic activity in the next few quarters. Volatility should also be expected, as the impact of a fast-tightening cycle becomes clearer. In the corporate space, hits to growth normally follow rate rises and multiples tend to trough before earnings bottom. Sector dispersion is significant, but many are yet to price-in higher real yields, and consensus expectations are not forecasting meaningful declines in margins from elevated levels. From the consumer side, domestic savings have provided a buffer but these are steadily decreasing while spend on credit is increasing as the cost-of-living crisis bites. The tightness of labour markets is often quoted as a reason why recession will be skirted, but it may just be postponing or masking recession risks, not eliminating them. The mismatch between labour demand and supply is concentrated in a few sectors rather than being broad-based, whilst concurrent trends, such as a slowing in hours worked, suggest weakness to come.
During previous periods of uncertainty, risk markets have been helped by the 40-year bond bull market. That is over. We believe we have entered a new era where asset allocation decisions will be influenced not only by how quickly we enter and exit recession but by what additional risk premia is needed in a world of structurally higher - and perhaps less predictable - ‘risk-free’ assets.
One thing is clear – government bond yields have reset higher and higher yields reflect more risk across all markets. Risky assets have not, however, re-rated to the same extent as ‘risk free’ assets; equity yields have risen to pre-Covid-19 levels but the excess yield from equities over bonds has reduced and reversed, altering the relative preferences of investors. Credit spreads had widened but recent retracement has effectively priced-out a recession and default cycle. Despite this, all-in yields are more important than the constituent parts and are more attractive than they have been for many years. Momentum suggests more money will flow into fixed income markets, and limited supply in the face of strong demand means the technical picture is on the investor’s side (even if the easy money has already been made). Our perception of the risks means a meaningful allocation to more defensive fixed income assets is warranted but if inflation were to ebb away and rates stabilise (or even fall) without a deep economic downturn risk assets could respond positively.
Important disclosures
This material is provided by Aegon Asset Management (Aegon AM) as general information and is intended exclusively for institutional and wholesale investors, as well as professional clients (as defined by local laws and regulation) and other Aegon AM stakeholders.
This document is for informational purposes only in connection with the marketing and advertising of products and services, and is not investment research, advice or a recommendation. It shall not constitute an offer to sell or the solicitation to buy any investment nor shall any offer of products or services be made to any person in any jurisdiction where unlawful or unauthorized. Any opinions, estimates, or forecasts expressed are the current views of the author(s) at the time of publication and are subject to change without notice. The research taken into account in this document may or may not have been used for or be consistent with all Aegon AM investment strategies. References to securities, asset classes and financial markets are included for illustrative purposes only and should not be relied upon to assist or inform the making of any investment decisions. It has not been prepared in accordance with any legal requirements designed to promote the independence of investment research, and may have been acted upon by Aegon AM and Aegon AM staff for their own purposes.
The information contained in this material does not take into account any investor's investment objectives, particular needs, or financial situation. It should not be considered a comprehensive statement on any matter and should not be relied upon as such. Nothing in this material constitutes investment, legal, accounting or tax advice, or a representation that any investment or strategy is suitable or appropriate to any particular investor. Reliance upon information in this material is at the sole discretion of the recipient. Investors should consult their investment professional prior to making an investment decision. Aegon Asset Management is under no obligation, expressed or implied, to update the information contained herein. Neither Aegon Asset Management nor any of its affiliated entities are undertaking to provide impartial investment advice or give advice in a fiduciary capacity for purposes of any applicable US federal or state law or regulation. By receiving this communication, you agree with the intended purpose described above.
Past performance is not a guide to future performance. All investments contain risk and may lose value. This document contains "forward-looking statements" which are based on Aegon AM's beliefs, as well as on a number of assumptions concerning future events, based on information currently available. These statements involve certain risks, uncertainties and assumptions which are difficult to predict. Consequently, such statements cannot be guarantees of future performance, and actual outcomes and returns may differ materially from statements set forth herein.
The following Aegon affiliates are collectively referred to herein as Aegon Asset Management: Aegon USA Investment Management, LLC (Aegon AM US), Aegon USA Realty Advisors, LLC (Aegon RA), Aegon Asset Management UK plc (Aegon AM UK), and Aegon Investment Management B.V. (Aegon AM NL). Each of these Aegon Asset Management entities is a wholly owned subsidiary of Aegon N.V. In addition, Aegon Private Fund Management (Shanghai) Co., a partially owned affiliate, may also conduct certain business activities under the Aegon Asset Management brand.
Aegon AM UK is authorised and regulated by the Financial Conduct Authority (FRN: 144267) and is additionally a registered investment adviser with the United States (US) Securities and Exchange Commission (SEC). Aegon AM US and Aegon RA are both US SEC registered investment advisers.
Aegon AM NL is registered with the Netherlands Authority for the Financial Markets as a licensed fund management company and on the basis of its fund management license is also authorized to provide individual portfolio management and advisory services in certain jurisdictions. Aegon AM NL has also entered into a participating affiliate arrangement with Aegon AM US. Aegon Private Fund Management (Shanghai) Co., Ltd is regulated by the China Securities Regulatory Commission (CSRC) and the Asset Management Association of China (AMAC) for Qualified Investors only; ©2022 Aegon Asset Management or its affiliates. All rights reserved.