Inflation has not yet peaked
The possible overshoot of the US inflation spike has reinvigorated risk assets into a widespread frenzy. On the positive side, this moderation in inflation increases the chances of an economic soft landing. Since the United States is considered the leader of the rest of the world, this explains the pervasive optimism of the market.
Nevertheless, breaking a peak does not appear to be on the near-term horizon for Europe or the UK, so this is just a piece of information, albeit an important one. We are not yet at a stage where there is enough data to suggest a repositioning for the next leg of the cycle, ie the long-awaited pivot.
If we look behind the numbers, weakness has emerged in goods, such as the clothing. This implies that the expected relief from inflation may be accompanied by reduced business margins, lower economic growth and, ultimately, layoffs. This could be the reversal markets are anticipating, but the scale of the reaction suggests it may have been taken too optimistically as a positive for growth and jobs.
This dynamism drives a greater supply of investment grade securities in the primary market, with the risk of investors going overboard. So when slowing growth and rising unemployment take hold as the lagged effect of monetary policy materializes in the data, it could be like coming off a sugar rush.
Too optimistic about defaults
As we get closer to what could be “the most anticipated recession in history”some market participants seem to be underestimating the risk of fallen angels.
The downward earnings revisions are extending beyond the energy and chemical sectors, as more sectors suffer from slower consumer spending. However, the mixed results of big stocks, such as large retail chains, paint a cloudy picture. Some participants also expect defaults to rise gently to a benign 2%, but many of these forecasts are not compatible with the magnitude of the tightening we have seen in monetary policy and financial conditions.
Taking macroeconomic variables into account, these forecasts indicate that defaults could exceed expectations. At Janus Henderson, we believe that investors should act cautiously in this end-of-cycle environment.
For example, the US Federal Reserve’s most recent survey of senior loan officers indicates a further weakening in demand for credit and a tightening of lending standards, in line with the situation in Europe and the UK . The survey has historically shown a strong correlation with delinquency rates – despite a deliberate pullback as part of the unique COVID policy response.
Tightening of lending rules correlates with default rates
a bumpy ride
It is likely that awaits us rocky road as markets balance optimism with reality. The shape of this slowdown is unlikely to be similar to that of the pandemic, in which central banks came to the rescue.
Backed by quantitative easing in the past, we believe that could take 18-24 months to control inflation. Although markets are anxiously trying to signal the turning point, we believe there will be more bouts of volatility before there is a turn in the cycle. There are no guarantees that past trends will continue or that forecasts will come true.
One way to view the markets is to consider the sharp deterioration in liquidity in the UK gilt market this year, and then compare that to the optimism seen following the recent government bond inflation data.
In the United States, comparatively, such abrupt movements have only been seen five times in the last 30 years. Four during the global financial crisis (CFG) and one in 1995, with the change in policy of the then Federal Reserve Chairman, Alan Greenspan.
Investors should expect a different playbook than the rear-view mirror perspective of the past two years. The data suggests that volatility may be with us for a while, and while market rallies and corrections can be significant, we must exercise caution in allowing market movements to dictate a new narrative. Therefore, a prudent approach is warranted in traversing this cycle.
Loan Portfolio Manager at Janus Henderson.
Source: Ambito
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