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Fixed Income
Macro insights: Resilient growth buoys markets, but risks elevated
KEY TAKEAWAYS
  • Resilience in various economic sectors and regions may be leading markets to underappreciate the extent of downside risks to growth
  • Moderating inflation should limit the extent of additional monetary tightening
  • Select exposures in fixed income - from duration and yield curve to securitised debt - offer attractive opportunities but overall risk asset valuations are less compelling

Investors powered a broad rally in risk assets in the second quarter as recession concerns appeared to diminish. Equities gained and credit spreads tightened as banking sector worries receded for now and Congress passed a US debt ceiling bill. Treasury rates rose amid solid economic data and as officials at the Federal Reserve (Fed) pushed back on easing expectations. Markets appeared to be lowering the likelihood of policy rate cuts and more adverse growth scenarios in the near term. As a result, the yield curve inverted further, reversing the steepening that occurred in the depths of the banking crisis in March.


Growth may continue to be resilient even as it slows, but risks skew to the downside. Markets reflect a sanguine growth outlook as robust labour markets and wage growth - even with some softening - have underpinned a healthy consumer. Even as the manufacturing sector contracted, consumer spending has been durable and supported the services sector of the US economy. While a path to a “soft landing” or continued growth remains a possibility, the banking sector crisis has exacerbated a tightening in credit extension broadly and represents a headwind to growth. Furthermore, the global growth picture is mixed. Stubbornly elevated inflation in Europe has meant more restrictive central bank policy even as growth momentum wanes, particularly in the eurozone. China’s growth has also disappointed with the manufacturing sector stagnating and service sector recovery slowing.


Investors have largely priced out recession scenarios

Investors have largely priced out recession scenarios

As at 30 June 2023. 2s-10s spread reflects difference between 10-year and 2-year US Treasury yields. High yield is the Bloomberg US Corporate High Yield Index. Shaded regions represent Q223. Source: Bloomberg 

US economy has shown resiliency, but global picture mixed

US economy has shown resiliency, but global picture mixed

As at 30 June 2023. Citi Economic Surprise Index tracks economic data relative to consensus forecasts of economists. Above 0 indicates data better than forecasts while below 0 is worse. Source: Refinitiv Datastream

Inflation in the US appears to be moderating. Headline Consumer Price Index (CPI) has decelerated to 3%, a sharp decline from last year’s peak at over 9%. The relatively “stickier” components, including shelter, are also off their highs. While goods inflation has slowed more quickly, even non-shelter services inflation - a measure often cited by the Fed - has been trending lower. This deceleration trend appears to be broadening, with over half of the CPI basket components reflecting inflation below 4%. Even so, strong wage growth and a resilient labour market are likely supporting the elevated rate for core inflation. The Fed has noted that their preferred inflation measures may not reach their 2% target for a few years.


Central banks have struck a hawkish tone recently, but inflation trends and the macro backdrop suggest further tightening may be limited. Officials likely want to counteract any unexpected easing in financial conditions and preserve optionality, but decelerating inflation suggests restrictive policy is having an effect. If inflation continues to slow and labour markets soften, growth considerations may play more of a role in the Fed’s policy decisions. The Fed could keep rates at elevated levels for some time, but markets may be underappreciating the potential for a more meaningful slowdown in growth and a resulting shift in the policy rate path.


While markets appear more optimistic, growth uncertainty and less compelling risk asset valuations warrant a more conservative stance. Traditional risk asset valuations appear less attractive and we favour a more selective approach, particularly if growth momentum slows further. After recent market moves, interest rate and curve exposures may offer better risk-reward trade-offs. Valuations also appear more compelling in mortgages and certain types of securitised credit, where compensation for the economic backdrop is more reasonable. In addition, dispersion within sectors of fixed income, such as corporate bonds, create attractive relative value opportunities that could offer better return potential than generically overweighting the sector.


Credit tightening evident in supply and demand metrics

Credit tightening evident in supply and demand metrics

As at 30 June 2023. Sources: Senior Loan Officer Opinion Survey on Bank Lending Practices. Board of Governors of the Federal Reserve System.

US inflation has continued to moderate 

US inflation has continued to moderate

Inflation data as at 31 May 2023. Shelter includes rent and owner ’s equivalent rent. SAAR is the seasonally adjusted annual rate. Source: US Bureau of Labor Statistics


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