Playing the patient game

Market focus has moved on from the debt ceiling since the threat of default was taken off the table.

The resolution of the US debt ceiling in the past week saw limited reaction in financial markets, given how this had been widely discounted. However, the removal of uncertainty is seen as a positive at the margin. Meanwhile, US credit default swaps rallied from 160 basis points (bps) to 30 bps in 1-year maturities, with the threat of default taken off the table. Having sold US credit default swaps (CDS) protection at elevated levels, we are content to retain this exposure and continue to benefit from the residual uplift in yield.

Elsewhere, the focus of equity markets has been the recent rally in artificial intelligence (AI) stocks, which has pushed the capitalisation of Nvidia to USD1 trillion, making it the 5^th largest US stock by market capitalisation. Price performance in AI stocks has been bubble-like in recent weeks, yet such is the recent frenzy in the space, it feels risky wanting to express an opposing view.

At a macro level, the accelerated deployment of AI may see some jobs replaced, but as with other technologies, other jobs are likely to be created. Technology is seen as disinflationary over the medium to longer term. However, from a shorter-term perspective, it seems the path of prices is going to be determined more by prospects for wages and other cost inputs.

In this context, some further moderation in headline inflation seems likely in data for May yet forecasts for the growth in US core prices remain above 5%. If this outcome is recorded and the US jobs market shows limited signs of slowing, it seems likely that the Federal Open Market Committee (FOMC) will conclude that it is right to hike again at either its June or July meetings, taking the effective Funds rate to 5.35%.

For now, rate cuts in 2023 seem like a distant prospect. However, we do think that monetary policy tightening will progressively act to slow economic activity, as we move through the year ahead. This should see price pressure moderate further. Once inflation does trend below 3%, then there may be meaningful rate cuts to follow in 2024, with policy now well into restrictive territory. Yet, with longer-dated Treasury yields currently sitting 175 bps below the levels where cash rates may peak, it is difficult to become too bullish with respect to the prospects for duration.

Markets already discount cash rates dropping to a long-term equilibrium of 3% by early 2025. Therefore, a bullish assessment requires faith that the FOMC will be able to take rates below this level, inferring a high level of confidence that inflation will return to, and remain at, the Federal Reserve’s (Fed) target of 2%.

Across the Atlantic, a bigger than forecast drop in eurozone inflation in May pushed European yields lower over the week. Meanwhile, indicators of economic activity have been consistently below prior estimates in recent weeks. In part, this could be tied to data disappointments coming out of China. This has pushed the Citi index of Economic Surprises in the eurozone to -63, which is the lowest level since the dip in sentiment in Q2 last year, when the onset of war and an escalating energy crisis were the catalysts to depress sentiment.

Nevertheless, we would not become too pessimistic about the EU outlook and remain confident that the European Central Bank (ECB) will continue to hike at both its June and July meetings, before pausing, with rates at 3.75%. This would represent a level 150 bps above 10-year Bunds. As with the US, at this valuation we struggle to get too excited by yields from a long duration perspective.

On a relative value basis, one clearer opportunity, which has stood out to us in the past week, is with respect to long-dated inflation break-evens between the US and the eurozone. Typically speaking, we expect to see US breakeven inflation above the level of the eurozone by about 50 bps. This is because the Fed target Core PCE inflation, which typically averages around 0.50% below the CPI basket. Hence, US inflation at target infers 2.5% on US CPI, whereas the contrasting figure would be 2% in the eurozone. Consequently, we think that it is anomalous that long-dated break-evens on inflation swaps should discount higher future eurozone inflation, than inflation in the US, and we would expect this relationship to reverse.

An improving picture for eurozone inflation could possibly herald some further moderation in UK prices to come in the coming weeks. With oil and gas prices dropping, this should be positive news even if the outlook for UK CPI continues to look consistently higher than we see elsewhere. Yet, with the Bank of England (BoE) seemingly retaining a relatively dovish bias, we are starting to think that there is scope for the BoE to deliver fewer hikes than the 100 bps discounted through the end of this year.

If both the Fed and ECB are on hold in a couple of months from now, so it is possible that the BoE does not exceed 5% on cash rates, especially since the pound has held up relatively well thus far. Although we continue to look for the pound to weaken, with Gilts now yielding 200 bps above eurozone peers, we think there is a lot of bad news already embedded in the price. Meanwhile, the notion that the BoE may under-deliver on hikes may suggest that there is now value to be exploited at the front end of the UK yield curve.

In corporate credit markets, eurozone paper continues to trade heavily relative to issuance in the dollar market, where underlying structural demand appears to be more robust. Subordinated financials have been trading somewhat better over the past couple of months, following the sharp losses in March in the wake of SVB and Credit Suisse. However, senior bank debt continues to trade at historically wide levels, not far from where spreads sat in the midst of the Covid crisis in March 2020.

Given the much larger index weighting towards financials in euro credit, this largely explains why index spreads in the region are higher than in the US, notwithstanding slightly shorter average duration and higher credit quality. Elsewhere in credit markets, securitized spreads have also been under pressure this year. Notably, high-quality collateralised loan obligation (CLO) spreads have moved beyond 200 bps in AAA-rated tranches and securitised collateral in commercial and residential mortgages has been relatively unloved.

In FX markets, the dollar has continued to push stronger over the past week. The removal of the debt ceiling risk, plus some narrowing in the projected quantum of forward-looking rate hikes between the US and the eurozone, have both helped to benefit the dollar. However, we are sceptical that we have moved into a strong dollar regime in FX. We have also continued to be surprised at the weakness in the Norwegian krone and the ongoing resilience of the pound. Neither of these moves appears justified by fundamentals, yet we remain confident that fundamentals will dominate over the medium to longer term, causing a reversal of recent trends.

Over the past couple of months, it has felt that there have been a number of cross currents in markets, leading prices in many assets to trade sideways. In this landscape, it is important to try to identify themes, which have a clear structural anchor, and seek to position accordingly. This has seen us maintain a short stance on Japanese yields, a bearish assessment of the UK pound, and long positions in senior eurozone bank debt and select sovereigns, such as Romania. Each of these trades has a solid underpinning and we do not see our investment thesis being challenged. Yet, in many respects, we seem to be sitting waiting for these opportunities to play out; something we see as likely during the second half of 2023.

Elsewhere, we have been looking to enter trades where we think markets have overshot and diverged from fair valuation. This has served us well in our analysis of US CDS. More recently, we would see positions we have been adding in EU/US long-term inflation differentials and in short-term UK interest rates, in this light. Otherwise, we are continuing to look for more tactical opportunities as they may arise.

Looking ahead

Near-term gratification is always welcome, but sometimes patience is the key to delivering results in investments. Reflecting on the benefits of patience, Biden seemed to do a good job of keeping his cool and waiting for events to play out in the recent debt negotiations. Indeed, one can argue that age and experience can bring the benefit of wisdom in such situations. Let’s hope that collective wisdom can also be applied to the boom in AI, lest we live to regret our mistakes…