Investment Strategy Insights: Keep an Eye on Generative AI

Stance: Surprisingly strong nonfarm payrolls in January, robust retail sales, and a slower decline in the Consumer Price Index (CPI) have led the market to reassess its expectations, with more rate hikes now priced in for 2023. Overall, however, slower growth and disinflation trends remain intact. Core CPI excluding shelter printed below 0.2% month-over-month for the fourth consecutive time, and when considering that no full-time jobs have been added in the economy since last year’s second quarter, labor market fundamentals seem less strong than what the latest Job Openings and Labor Turnover Survey (JOLTS) is reporting: a rise in openings to more than 11 million. Warm January weather is possibly behind the seasonal pop in retail sales, with the non-seasonally- adjusted numbers showing a broad sideways move since mid-2021. That dovetails with utilities production, which fell the most on record for any January. There will be heightened focus on February numbers, therefore, to ascertain whether the “strong” January data indicates a true change in trend. In Europe, fears of a near-term recession have been assuaged with the alleviation of the gas shortage, but data has yet to turn. Retail sales and industrial production are in contraction as loan data has turned sharply lower in the face of a hawkish European Central Bank (ECB). Conversely, China’s reopening has been quicker and stronger than expected, as shown by loan data and purchasing managers’ index (PMI), which is above 50.

Outlook: While China’s rebound should be less dramatic than in previous cycles, it should translate into a better global economic backdrop in 2023 than what was previously expected. US growth still seems set to slow, with a possible secondary tightening in financial conditions driven by a more hawkish Fed tone.

Risks: 1) Secondary tightening in financial conditions catching the Fed off guard; 2) an increase in geopolitical fears; and 3) more resilient economic fundamentals across Europe and the US.

Our neutral outlook last month lasted for a nanosecond, after which we became bearish. At the Federal Open Market Committee (FOMC) press conference on 1 February, Fed Chair Jerome Powell mentioned disinflation 15 times, yet nonfarm payroll figures, the Producer Price Index, CPI, and retail sales are all accelerating. As we approach and hit 4%, we will add duration. We have made incremental additions to duration at 3.75% and 3.85% on 10-year Treasuries, are neutral at 4%, and overweight higher than that.

The fundamental global economic outlook has continued to surprise to the upside, resulting in a decline in recession probabilities. Offsetting this optimism is the market’s realization that the Fed is not going to cut rates in 2023. As a result, rates volatility has returned, with the potential for a longer period of higher terminal rates. Despite strength in near-term economic data, we continue to expect earnings deterioration and the lagging effects of higher rates as the year progresses.

Despite some backsliding late in the month, spreads have tightened from January, with rate sensitivity driving returns. After dropping below 400, high yield (HY) spreads are back near 420 levels, while IG spreads have returned to the 110s. The BB-BBB differential has widened to 130 but is not sufficient to change our tilt of favoring IG over HY. However, single-B HY has wider dispersion and sufficient value such that we would maintain current HY exposures. The return of collateralized loan obligation (CLO) issuance and growth in the pipeline has provided strong technical support to the loan market. While demand for mezzanine CLO tranches remains more challenging, strong demand toward the top of the capital stack has resulted in substantial spread tightening relative to IG credit and sufficient equity arbitrage despite higher loan prices. With greater economic optimism in Europe and China, the differential between US and European/ emerging market (EM) spreads has continued to narrow. Therefore, we would pause adding to European or EM exposure relative to US credit.

The US disinflation narrative, which weighed on the US dollar in recent months, has hit a few speed bumps in recent weeks with the release of significantly higher-than-anticipated nonfarm payrolls, red-hot retail sales, and a slightly disappointing CPI print. Global sentiment has turned weaker as a result, temporarily reinvigorating the US dollar. Rate differentials remain the key driver of a resurgent US dollar in the short term, while a surprisingly aggressive tightening stance by the ECB should support the euro over a 12-month timeframe. Current US data uncertainty and the Fed’s data dependence have pulled the May FOMC meeting into play, almost entirely ruling out 2023 cuts and bolstering the near-term US dollar outlook. We advocate using short-term US dollar strength to reposition for a weaker US dollar in the second half of 2023 as US economic activity fades and the Fed goes on pause. Our new 12-month euro/US dollar forecast at 1.05 (from parity) makes us more neutral over that investment horizon. Also, the US dollar tends to have a negative relationship to global growth, underperforming EM currencies during periods of a US-only recession.

China’s reopening helps bolster EM activity and supports a widening of its growth differential with developed markets (DM). The appointment of Kazuo Ueda as the Bank of Japan’s governor paves the way for exiting yield curve control in Japan, yet the bar is still high for removing the BOJ’s negative interest rate policy. Extreme short yen positions have been reversed, suggesting the yen could be in for a technical setback on the market’s realization that Ueda may prove more conservative or neutral than hoped.

Driven by China’s reopening and firmer US economic data, we see a rising probability of a soft landing. This makes EM corporate IG more attractive than US IG and EM sovereign IG on a risk-adjusted basis amid lower leverage, higher average credit ratings, and considerably shorter duration. Local currency debt also offers an attractive alternative, but we recommend being selective, favoring Mexico, Colombia, Indonesia, and South Africa. China’s reopening is positive for all EM areas, helping Latin America overcome the headwinds of a US slowdown, with boosts coming for metals and mining, pulp and paper, and industrials and diversified companies, particularly chemical producers, and for protein-sector companies. In Asia there are positives across the board, with Macau, Hong Kong, and Thailand the standout winners. Central and Eastern Europe, the Middle East, and Africa (CEEMEA) will feel a small indirect impact from China, although commodity industries will benefit directly. We note that a one-percentage-point gain in Chinese growth leads to a 0.2-percentage-point rise in euro-area GDP, which benefits CEEMEA companies. One sector that benefits but is not always obvious is real estate. Even with the expectation that China’s growth now will be more consumption-driven than investment-led, China’s reopening still puts a floor under commodity prices but at the same time will help keep costs in line by normalizing supply chains. We raised our “soft landing” probability to 20% from 10%, reduced our “classical” outlook to 50% from 60%, and maintained our “pivot” and “stagflation” probabilities at 20% and 10%, respectively.

China’s reopening and Europe’s mild winter not only have reduced the odds of a global recession, but also have changed the landscape of investment opportunities. For that reason, we have become slightly more constructive, primarily to make room for select opportunities in EM that previously had been attractive from a valuation perspective but lacked the prospect for improving fundamentals. For most developed markets, we remain just as cautious as before. We still see a profit recession unfolding in the West and worry that goods deflation is now running unsustainably fast and may even prove transitory by the second half of the year, making the goal of sub-3% core inflation difficult to achieve. In the US, a puzzling and long divergence has developed between lagging “hard” economic data and leading “soft” data (such as PMIs and confidence surveys). Many of these lead/lag relationships form the basis for expectations of a recession in the second half. From top-down and bottom-up data, there is evidence that the economy is still being buffeted by outsized backlogs that built up because of Covid-induced supply chain constraints. While these backlogs are now dwindling, they still must be fulfilled. Even in real estate, which has slowed sharply as mortgage rates spiked, backlogs have continued to support homebuilders, delaying what looks to be an inevitable rise in construction unemployment by the second half. We think excess savings, to the extent they exist, also will likely give way by the second half.

Fourth-quarter earnings largely have come in as expected, with the economy still showing surprising resilience despite dispersion in end-market outlooks. The picture for the second half remains uncertain, with easing inflation and China’s reopening providing some offset to the cumulative impact of Fed rate rises. The market appears willing to look past near-term concerns about a recession, the most-anticipated downturn in decades. Stocks and sectors seen as secular growth beneficiaries are benefiting from investors’ willingness to look past the next six to 12 months. The dispersion in end-market fundamentals and the debate about the severity of a potential recession have caused continued volatility. As a result, we continue to see opportunities to upgrade the portfolio and invest in advantaged companies at valuations below typically high levels. As always, portfolio style balance remains a key component of our risk management.

While some segments show improving results, higher valuations will require even better financial performance to move the market higher. As a result, we are keeping our score unchanged. In China, consumption is recovering well, with the pickup in service and travel most notable, while auto and property sales remain lackluster. It is yet to be seen whether individual industries can recover to pre-Covid levels. In India, quarterly results continue to show broad-based growth, with technology companies doing well and financials growing, with balance sheets becoming stronger. Commodity stocks, as expected, were under pressure due to falling prices, while consumer stocks faced demand headwinds. Fourth-quarter results show that demand for discretionary items slowed, probably in reaction to high inflation and high interest rates. In Latin America, quarterly performance among consumer and financial companies generally has been strong, although the bankruptcy of a Brazilian online giant and instability in Peru were felt keenly in some banks’ results. Areas of earnings strength in Latin America include commodities, consumer goods, most financials, and most things Mexican. EM Europe has largely adapted to the war’s impact, while the Middle East and Africa generally are neutral or beneficiaries.

Our US Conviction Score remains unchanged at 4.08, with contributions from a flatter curve offset by tighter credit spreads. Our global credit forecasts remain positive on EM and negative on DM. In DM, our model favors banking, finance companies, insurance, and basic industry. It dislikes financials, natural gas, electrics, technology, and utilities. It turns negative on energy. In EM, the model likes Argentina and China and dislikes EMEA and South America. Among EM industries, the model likes metals and real estate and dislikes pulp and paper, infrastructure, and utilities. Our global rates model forecasts lower yield (smaller in magnitude compared with last month) and a flatter curve in Europe, the UK, and Oceania, but little change in curve shape in North America and Japan. The rates view expressed in our G10 Model portfolio is overweight global duration. It is overweight North America and Japan and underweight Europe. Along the curve, it still positions for flattening, with overweights in six-month, 10-year, and 20-year durations and underweights in two-year, five-year, and 30-year durations.