Investment Strategy Insights: Labor Market Insights From Credit and Equity Markets

Stance: While our “Stabilization” base case continues to anticipate a soft landing, US economic surprise indices are declining. Labor market weakness has become a major concern in recent months, indicating a clear downward shift in the direction of the US economy. The saving grace has been US consumer strength and robust retail sales. With the ratio of net worth to disposable income running near all-time highs, if the data is not revised downward, it will be difficult for the US economy to experience a sharp decline unless the Fed fails to start its easing cycle.

As US inflation continues to moderate, with CPI below 3% for the first time since 2021, Fed speakers are hinting that sufficient progress has been made toward meeting the Fed’s inflation goal within its dual mandate. In addition, the rise in the unemployment rate to 4.3% – albeit still low by historical standards – suggests monetary policy is restrictive, warranting calls for the Fed to start easing at a gradual pace. July non-farm payroll growth slowed to 114,000, keeping the three-month moving average broadly steady at 170,000, but down from 242,000 at the start of 2024. While the trend is toward moderation, there is evidence to suggest that the downside surprise was driven by weather effects and seasonal factors, making it harder to distinguish the signal from the noise. The latest jobs data did trigger the Sahm rule, indicating an increased risk of entering a recession. Since the dynamics behind the rule are powerful and its noteworthy predictive ability should raise alarm bells, former Fed economist Claudia Sahm has since highlighted that the rule is more of a formula for seeking government relief than a forecast or foolproof indicator of imminent recession.

Equity markets have moved back to pricing between three and four rate cuts this year following initial market panic on the release of July employment data. Market talk of an inter-meeting cut or a jumbo cut in September was pulled back after US retail sales came in stronger. China’s consumer data have begun to sputter again, raising concerns about the economy’s trajectory and sparking renewed calls for fiscal stimulus.

In late April, we favored long duration when the 10-year note hit 4.70%. We were looking for a move of over 50 basis points and a break of 4.20% to exit. We continued that conviction through June, and the anticipated decline in yields has happened. We held a portion of our overweight, anticipating war escalation under a leadership void that would lead to demand for Treasuries, and forecasted a possible break to below 4.00%. Looking at the Congressional Budget Office numbers, interest payments are forecasted to skyrocket and dwarf all other spending programs. Interest payments today already surpass the military budget.

The volatility and economic concerns that arose at the start of August were short-lived, causing credit spreads to quickly retrace much of their initial widening, which had briefly resulted in attractive valuations. Shortly after the July Fed meeting, poor employment data caused the market to price in material recession concerns and overreact in its expectations of aggressive rate cuts. As the yen rallied and the unwinding of the yen carry trade added to technical pressures, credit spreads widened, with investment grade (IG) spreads reaching intraday highs near +120 and high yield (HY) spreads near +450 on 5 August.

The year has been characterized by a series of overreactions with respect to Fed easing expectations on short-term economic data. While the trend is certainly one of decelerating growth, we are still of the view that the US economy is gliding toward a soft landing. Furthermore, even if there is a “recession,” it will be quite mild and will not result in spreads widening to prior recession levels. While the Fed should commence its easing cycle in September, we believe it will be more gradual in the early stages than what the market has been pricing in.

While spreads have largely recovered from early August’s widening, they remain closer to fair value from their arguably somewhat overvalued level a month ago. Therefore, we have improved our CS but remain slightly cautious. This year’s story has been largely about yields rather than spreads. While yields remain elevated compared to levels a few years ago, they are at year-to-date lows, with IG now below 5% and HY below 7.5%.

The US dollar has been on a weakening path in recent weeks, reflecting rising concerns of a US economic downturn and higher probability of a US recession over a 12-month horizon than seen all year. Yet fears of an imminent recession due to the triggering of the Sahm Rule appear overstated. Our central scenario remains one of “Stabilization,” which means a slowing US economy and moderating inflation, allowing the Fed to reduce interest rates at a measured pace, starting in September with a rate cut of 25 basis points (bps). While the market focus is shifting from an inflation regime to a growth shock regime, speculation about an inter-meeting rate cut by the Fed or a 50-bp rate cut in September runs counter to the underlying strength of the US consumer and Fed Chair Powell’s reputation as “Mr. Nimble.”

US politics remains a risk factor to our 12-month outlook. However, as the probability of a Red Sweep has dissipated, so has the tail risk for markets.

Notwithstanding the rise in volatility in July, the current economic and market outlook suggests a return to stability, at least until the November elections. That said, markets will be on tenterhooks around every US jobs data release for any signal that the US downturn is accelerating. In the meantime, the US dollar should trade within its recent range. Reflecting the fact that it is now at its weakest point since January, we can see room for some US dollar strength in coming months.

Unwinding of the carry trade in July was in part triggered by the sudden, sharp appreciation of the Japanese yen. To the eyes of the incumbent prime minister heading into this year’s general election, the weak yen had an unwelcome influence on public sentiment. The volatility seen in the wake of steps taken by the Bank of Japan and the Ministry of Finance to support the yen was equally unwelcome; the Bank of Japan prefers a stable market and a stable yen. On a historical basis, the yen remains undervalued but has been struggling with continued outflows and an interest rate differential with the US that is too wide. The current valuation around 146.00 in dollar/ yen terms is more reflective of the future path of the yen, and we have adjusted our 12-month dollar/yen forecast lower to 145 from 155.

The macro environment for emerging markets (EM) remains favorable. Domestic demand proved more robust than expected in the first half of the year, preventing a slowing of growth momentum. A normalization of growth rates in the second half will continue to support EM assets. Our expectation for commodity prices is also optimistic for the asset class. After the weaker-thanexpected labor market numbers for July, we saw concerns about a more significant slowdown in the US economy, combined with an unwind of popular carry trades that led to a spike in EM spreads and weakness in EM foreign exchange. Later in August, however, markets calmed, with strong retail sales leading to an increased belief in a soft landing. A soft landing and a Fed poised for rate cuts create an environment where EM assets can perform well. We continue to see EM fundamentals as robust. We expect that the market will differentiate among EM markets to identify where good policymaking and a credible direction of travel for fiscal and monetary policy can be found.

The prospect of Fed cuts raises the possibility of further inflows into the asset class and increases the likelihood of a reopening of market access for some lower-rated countries, which have been priced out so far. That will benefit sentiment, and we should expect prospective issuers to come to market before the US election.

In the corporate space, the EM fundamental picture remains resilient. Second-quarter earnings are coming in better than expected. Valuations have been mixed, but the supply-side technical picture remains very solid. As with sovereigns, we expect a busy September for supply. Approaching November, investor attention should shift toward the US elections and how the decision will affect the macro picture. With valuations remaining balanced, the high carry and robust fundamentals should offer some support to the asset class in an adverse outcome.

Signs of a slowdown have emerged in the US and Chinese economies, contributing to the rapid deceleration of inflation. New data reports raise the possibility that the Fed will fall behind the curve, increasing the risk of a hard landing. Markets will only know if the landing is hard or soft after the fact. In the meantime, risks are becoming asymmetrically skewed to the downside. As a result, we revised our CS early in the month to 3.5 from 2.5.

While we haven’t seen a definitive crack in the economy, smaller cracks are rapidly emerging. Meanwhile, the Fed appears to be waiting until September to make its first policy rate cut. China, too, is in “wait and see” policy mode, postponing its Third Plenum stimulus to reserve ammunition should the US impose 60% tariffs in the first quarter of 2025. At the same time, the People’s Bank of China is implementing quantitative tightening (QT) and the Bank of Japan is finally ending free money.

Geopolitical risk is increasing, particularly in the Middle East. Importantly, supports for our soft-landing view – a stealth fiscal thrust, a wind-down of the rolling manufacturing recession in consumer goods, and consumer incomes deflating slower than prices – are fading.

With the risk of a hard landing now approaching 50%, we dialed back our risk to stabilize portfolio values. We consider our current 3.5 score to be a temporary resting point while we wait to see whether central banks can avert a hard landing by pulling their easing forward and upping its forcefulness.

Equities in developed markets (DMs) are navigating through a period of heightened volatility marked by a VIX spike, a large carry trade unwind, and a momentum unwind. The debate is now more two-way, with valuations at the top end of historical multiples at the same time that early signs of a slowing economy are emerging. Lower-income consumers are more stretched, and recession concerns are inching up from low levels. The first Fed rate cut should come in September.

The earnings picture is good, with the second quarter showing improvement over first-quarter results as destocking winds down and companies see stable to improving 2024 outlooks. Earnings growth has mainly been driven by US tech and AI-driven spending. Contribution to earnings growth is starting to broaden to other sectors. Geopolitics and election-related policy uncertainty, coupled with high valuations and ongoing signs of slowing, could lead to prolonged volatility.

Sales at China’s largest real estate developers fell 21% year-over-year in July. In financials, all state-owned banks have announced RMB deposit rate cuts of 5 bps to 15 bps to protect their net interest margins as loan growth slows. Consumer demand continues to be relatively weak, with promotional activities becoming more common in categories including beer, dairy, and restaurants. In India, second-quarter reports contained few surprises. Sectors related to global demand, including IT services, showed signs of bottoming out, while sectors related to discretionary domestic consumer demand – building materials, automobiles, travel, and hospitality, for example – have seen a softening in the pace of post-Covid recovery.

In Brazil, rising CPI expectations, foreign exchange depreciation, and fiscal imbalances may cause more uncertainty. However, those issues are likely priced into Brazilian equity valuations, as most sectors trade below their historical median. Retail sales are accelerating, which has been reflected in earnings beats at many consumer names. Retailers with in-house credit issuance stand to benefit as delinquencies fall and credit growth accelerates. In Mexico, earnings have been unaffected so far by politics, and equity declines have primarily been driven by a deterioration in multiples. In EMEA, earnings reporting continues, with beats from banks and healthcare.

The market’s breadth has improved from the highly concentrated levels seen earlier in the year. Macro and geopolitical concerns remain a factor, but not to the same degree as in the year’s first half, which is generally helpful to our investment approach. In our investment decisions, we try to look as much as possible past such factors and 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 curve steepening of 15 bps and a credit spread that barely moved. Our global credit forecasts are negative, and our relative model favors EM over DM. In DM, the model favors banking, insurance, and technology; it dislikes transportation, consumer goods, and utilities. Among EM industries, the model likes infrastructure and consumer goods and dislikes transportation and real estate.

Our global rates model forecasts lower yields except for Japan, Switzerland, Norway, and Australia, and a steeper curve globally except for Japan, Denmark, and Sweden. The rates view expressed in our G10 model portfolio is overweight global duration. It is overweight Spain, Italy, New Zealand, Belgium, and Sweden, while underweight North America, the UK, France, and Germany. Along the curve, we are overweight the six-month, 10-year, 20-year, and 30-year while underweight the two-year and five-year.