Investment Strategy Insights: For a Read on the Health of Consumers, Check Their Employers

Stance: The weaknesses observed in the latter part of the summer appeared to dissipate in September and October. While headline non-farm payrolls slowed only marginally, considering revisions, they were consistent with a neutral growth rate. Wage growth and inflation remained high and displayed signs of stickiness but were on a downward trend. GDP growth also remained high but was adjusted downward, with expectations of weaker performance in the third and fourth quarters. The first significant shift in the labor market was indicated by a higher JOLTS report on August job openings, coming in at 9.6 million, versus 8.8 million for July. Payrolls followed, with impressively high job gains of 336,000 in September, supported by a two-month net revision of 119,000 and lower-than-expected wage growth at 0.2% month-over-month. Finally, retail sales growth was robust at 0.7% month-over-month, indicating that consumers were not struggling and were starting to take advantage of real wage growth to boost their spending. Consequently, many market participants removed recession expectations from their forecasts, leading to changes in anticipated inflation and significant movements in the rates market. This shift in the economic landscape is crucial as seasonal adjustments and underlying trends introduce ongoing uncertainty to the economic outlook.

The outlook for central banks is intriguing. Both the European Central Bank and the Federal Reserve are likely to cease their interest rate hikes and discuss extended pauses. However, the possibility of one or two more rate hikes remains on the table. With the improvement in the economic backdrop, the market has begun to factor in fewer projected interest rate cuts in 2024.

In China, the third quarter is likely to mark a cyclical bottom, with recently announced policy efforts starting to take effect. The slowdown experienced in the second and third quarters can be primarily attributed to limited fiscal support, as the Chinese government held an overly optimistic view of the reopening’s impact on economic growth. The expected rebound in the fourth quarter is contingent on property activities stabilizing after a significant decline last year, with the government’s modest fiscal expansion serving to counterbalance the decline in exports.

We are changing our stance from neutral to cautiously bullish as the 10-year moves above 5%, a level that forecasts missed. The rise happened in the middle of the United Auto Workers’ strike and a surprise terror attack in the Middle East. War and its threat almost always cause a flight-to-quality jump in demand for US Treasuries, but this time yields moved higher in opposition to expectations. The buzzword now in the US Treasury space is supply, as analysts pore over flows and note steady selling this year by Asian-based private and public accounts. Fiscal deficits show zero chance of slowing down, with a deficit forecast of $2 trillion for the next 10 years that no one disputes. Interest payments will exceed $750 billion per year for the foreseeable future and could pierce $1 trillion anytime between 2024 and 2027.

Rates continue to march upward despite an elevation of geopolitical risks from the Mideast. Will the underlying consumer strength eventually crack or continue to defy expectations in the months ahead? Credit spreads have remained in a stable range, and the volatility in credit has been primarily within the rates component. While spreads are not particularly cheap in the face of rising risks, the total yield and price convexity across credit makes for an appealing value proposition. With the most recent move in Treasury yields, we are now shifting to a neutral posture between floating-rate and fixed-rate credit, as the fixed rate is providing an element of downside risk protection. While our base case forecast still calls for higher current yielding floating-rate credit to outperform its fixed rate counterpart, the overall scenario of potential outcomes calls for closing the fixed-rate underweight.

The US dollar is riding a strong wave of US exceptionalism centered on the surprise resilience of the US economy in the third quarter, which stood in sharp contrast to China and Germany. While US inflation cooled over the summer, it remains sticky, and the Fed has signaled that without more pain, it will be difficult to achieve its inflation target within the forecast horizon. We are watching inflation and unemployment data for evidence of an economic slowdown to justify our view that monetary policy is sufficiently restrictive to drive economic activity lower – and after a sufficiently long pause, to enable the Fed to start cutting rates to reduce the high real yields. The risk to that scenario stems from the current momentum in the US economy driven by strong consumer spending within higher-income households and continued fiscal support. An extension of the “higher for longer” theme would support the US dollar against its weaker counterparts, the euro and the British pound.

While tailwinds from the unexpected fiscal thrust in 2023 may be waning into 2024, the geopolitical situation, worries over an imminent US government shutdown, and the 2024 US elections could all play a role in extending the current scenario of a stronger US dollar, which is benefiting from a combination of loose fiscal policy and contractionary monetary policy. Market participants appear to be underestimating the ability of the eurozone to withstand current downside pressures. As inflation remains sticky and labor markets tight, the ECB could end up shadowing the Fed and keeping interest rates on hold for the foreseeable future. Adding support to the euro/US dollar stability argument is that China’s economy hit a cyclical bottom in the third quarter. While the recovery is likely to be toothless into 2024, some of the downside risks have been mitigated by policy support.

The crisis in the Middle East stopped bond vigilantes from seizing control of higher US Treasury rates. History indicates that heightened geopolitical risk will lead to persistently greater rates volatility, which certainly is not welcome at a time of higher rates. Tighter financial conditions rather than geopolitics or growth data seem to be behind the Fed’s recent shift to a more dovish tone, but we must continue to watch the numbers for inflation, unemployment, and wages for clues into the data-dependent Fed’s next moves.

We also must watch oil prices, as current geopolitical events could disrupt supplies and drive prices higher. For 2024, we see growth headwinds coming from lower global demand, persistently tight regulations, and political forces favoring deleveraging, which point to any economic recovery being sluggish. Our 12-month scenarios offer a 50% probability of stabilization, 25% of recession, 5% of stagflation, 15% of an extension of existing trends, and 5% of an acceleration.

In September, bond markets dropped. Contrary to expectations of swift policy rate normalization, various trends are emerging: re-localized supply chains, climate initiatives, and Gen Y entering the housing market, potentially reducing the global savings surplus and tightening capitalization rates. Simultaneously, a substantial US fiscal push in 2023, the first in half a century, is driving economic resilience, but it requires funding. With central banks reducing their purchases and increased private sector demand, we shouldn’t be surprised by a significant rise in the cost of funds.

Looking at historical inflation shocks, an International Monetary Fund (IMF) study emphasizes the need for prolonged tight monetary and fiscal policies due to the potential for sustained inflation. Secular inflationary pressures that include bifurcating supply chains, climate change, and tight labor markets have been temporarily masked by transitory inflation, which is expected to recede. Central bankers are referencing this study, suggesting a focus on structural inflation.

China’s economy is recovering from the 2020-2022 recession, with improving indicators including purchasing managers’ indices (PMIs), retail sales, and property sales, which may ease transitory inflation. Chinese policymakers are emphasizing yuan acceptance as a reserve currency in the Global South, which would stabilize the yuan while allowing it to depreciate, adding upward pressure to the US Treasury curve. This de-dollarization poses downside risks to China’s economy.

While it’s hard to spot an imminent recession given the fiscal thrust, the combined impact of the Treasury’s escalating debt issuance, the Fed’s resisting such fiscal dominance through persistent quantitative tightening, and the resumption of student loan payments, along with growing labor strikes, the recent supply-induced oil price spike, and China’s green shoots, all add to the risks of long rates and the US dollar spiking until something breaks. We remain cautious.

While recession fears around the globe have eased, the market narrative has shifted to higher (rates) for longer, and whether this will eventually have a dampening effect on economic activity. For now, US consumer spending and labor markets are holding up well, though it is difficult to see how it gets much better from here. The world is no longer seeing “synchronized global growth” like it did when China was driving world economic activity. Now the cycles vary a lot both within regions and across regions, which creates opportunities for active managers. We continue to find opportunities to upgrade the portfolio and invest in advantaged companies at valuations below typically high levels.

Global emerging markets (GEMs) are being whipsawed by interest rate fears and two ongoing wars. The US decision to further restrict semiconductor-related activity with China creates economic and geopolitical uncertainty, as well as causing stock-specific fundamentals to take a backseat, at least temporarily. Since their recent peak on 31 July, GEMs are -9.5%, with industrials, consumer discretionary, China, and Latin America down the most. In China, third-quarter GDP of +5.2% gives hope that a recovery may be taking hold, but more evidence is needed; strong September retail sales were encouraging.

In India, the earnings reporting season opened with a good showing from banks, but light numbers from IT consultancies. A major Taiwan semiconductor manufacturer reported strong results and incorporated chip demand recovery in its 2024 estimates. Mexico’s president frightened markets with an abrupt tariff cut to airport operators and an investigation into Walmex, even though the latter was well flagged. In Eastern Europe, there is a reprieve on the political and economic front, as a pro-EU and market-friendly opposition in Poland won parliamentary elections, but a coalition government is still needed. South Africa continues to suffer from multiple problems and lack of reform. In the Middle East, the task of preventing a wider regional war is at the forefront. The US political impasse is adding somewhat to investor jitters as well. It seems we are again in a period when top-down and geopolitical currents have as much influence as company fundamentals. Some stocks are now heavily oversold. We continue to focus on companies with strong and improving business models, quality management, sound financial structures, and proper adherence to ESG values.

Our US Conviction Score improved, driven by steeper curve, which was up 32 basis points (bps). Our global credit forecasts are negative, and our relative model slightly favors emerging markets (EM) over developed markets (DM). In DM industries, our model favors energy, industrials, and insurance and finance companies. It dislikes electrics, utilities, natural gas, and REITs. Among EM industries, the model likes oil and gas, and pulp and paper; it dislikes real estate, utilities, and diversified industries. Our global rates model forecasts lower yields, and a steeper curve except for Japan and Norway, where the forecast is for a slightly flatter curve. The rates view expressed in our G10 model portfolio is overweight global duration. It is overweight North America, France, Belgium, and New Zealand, while underweight the UK, Germany, and most other parts of Europe. Along the curve, it is overweight two-year and 20-year durations and underweight five-year, 10-year, and 30-year durations.