2023's Home Stretch: What We Are Watching

Cohen

Economic

Stocks

Bond

Summary:

With the weight of elevated interest rates potentially cooling the appetite of the economic growth engine that is the U.S. consumer, Global Head of Multi-Asset Adam Hetts explains why investors should take a defensive stance by prioritizing quality companies and cross-asset diversification.

Along with the change of seasons in the northern hemisphere, global financial markets have decidedly cooled in recent months. We believe this reflects a widening range of economic outcomes as a much hoped-for soft landing becomes less of a sure thing. While it may appear that a resilient economy and steady corporate performance belie our growing sense of caution, we see a common thread among key indicators that reveals an environment that is potentially more fragile than many market participants realize.

Woe be the consumer?

As evidenced by blow-out third-quarter U.S. gross domestic product (GDP) data, the U.S. consumer continues to power the domestic economy. Consumption accounted for 2.69 percentage points of the aggregate 4.9% annualized quarterly growth rate. We don't know how much longer this pace can last. The bulge in personal savings owed to pandemic-era stimulus packages has largely run its course. Furthermore, consumption has more recently been powered by credit cards. With borrowing costs having reset to decade-plus highs, we question American households' desire – or ability – to keep racking up such purchases.

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Higher, longer, inevitable

Our reason for doubting consumption's durability is our long-held view that policy rates will remain elevated for longer – an assessment that is now largely accepted by the market. Compounding this risk is our belief that the U.S. economy – and others, for that matter – have yet to feel the full brunt of previous rate hikes. Relative to other tightening cycles, we are still in fairly early innings, meaning the curtailment of demand that is the intention of hawkish policy is still working its way through the system. Already business investment has slowed, with non-residential fixed investment contributing nothing to third-quarter GDP growth.

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Perhaps the most powerful signal that economic growth faces headwinds is the meteoric rise in real yields, with that of the 10-year Treasury at roughly 2.50%. This represents the highest cost of capital in inflation-adjusted terms in 15 years. Importantly, nominal yields have continued to climb even as inflation has subsided. We interpret this as the recognition of a potential regime change in rates. Consequently, corporate managers will likely become more selective when allocating capital, as returns on investments must meet a higher threshold.

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Markets: Staying invested, staying defensive

With both equities and bonds well beneath their mid-year highs, some investors may presume current prices adequately reflect the myriad risks posed by elevated rates. But we believe it's too early to sound the “all clear.” Within fixed income, mid- to longer-date Treasuries and mortgage-backed securities (MBS) have borne the brunt of the sell-off. Given our view that rates are likely nearing their peak in the U.S., these segments could merit consideration for investors seeking attractive yields.

This view, however, does not carry over to high-yield corporates, as the spread between their yields and those of their risk-free benchmarks remains below long-term averages. Our concerns for this segment are compounded by the risk of a harder-than-expected landing, which could stress some of these companies' leveraged business models.

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Similarly, we don't see risks dispersed evenly across the equities landscape. Over the course of 2023, mega-cap technology and Internet names have held up better than the broader market, and their valuations remain above their long-term averages. Yet unlike still-frothy high-yield credit, many of these business models, in our view, are well positioned to weather an economic downturn given their consistent cash flow generation, strong balance sheets, and exposure to durable secular themes. Value and more cyclically exposed names, on the other hand, could come under additional pressure in a slowing economy.

Despite gathering headwinds, earnings estimates for U.S. stocks have held up well during the sell-off, while estimates for ex-U.S. equities have proven softer. The resilience of tech's business models has likely played a role in U.S. estimates holding firm, but we are less confident in other sectors should the country's consumption engine lose steam.

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The merits of diversification

Lastly, a widening range of economic outcomes lends itself to increased market volatility. Uncertainty about the duration of elevated rates and rising geopolitical risks further clouds the situation.

When this type of volatility and uncertainty causes asset classes to move in tandem – as they have occasionally done of late – investors can lose sight of the need for diversification. After years of it not being the case, bonds once again have the potential to act as ballast to riskier assets in a broad portfolio. Yields have risen to levels that offer both attractive income potential and possibly lower levels of volatility if rates stay within their current range. And should a rapidly weakening economy force central banks to pivot – not our base case – bonds' potential for capital appreciation could offset losses in more cyclically exposed asset classes.

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Source: Janus Henderson, Adam Hetts

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