Not yet at peak inflation
Global Head of Fixed Income Jim Cielinski explains why he believes positioning portfolios for a downturn feels prudent and investors should resist the temptation to add credit risk too early, but a dovish pivot should not be overlooked.
- While inflation expectations alongside commodity prices have eased, a peak has not yet been seen in headline inflation in the second quarter. However, we should see a peak soon as energy base effects wash out.
- In our view, access to cheap capital is behind us as liquidity trends continue to deteriorate, lending standards get tighter and the cost of borrowing sharply rises.
- As demand destruction continues to filter through industries and geographies, recession has become more likely than not in many major economies over the next 12 months.
- With fundamentals set to weaken, dispersion between the winners and losers could increase, making security selection critical.
Jim Cielinski: Well, the calm in markets has certainly dissipated this year. One of the key drivers of that, I think, is uncertainty about central bank policy.
Credit is always a function of the underlying macro backdrop, and it’s here that we see the slowdown that we talked about last time really accelerating.
And so for us, the credit cycle had turned, we suggested that it was unclear until we knew what the central bank reaction function would be just how fast it might deteriorate. Well, three months later, we have gotten our answer. The Fed, for example, has moved up by 75 basis points. And for this, what it means is that they’re tightening into a slowdown, and with slowing growth it probably means recession is more likely than not in many major economies.
Some, like Europe, are seeing the genesis of a real energy crisis. China has slowed markedly, and the U.S., perhaps the healthiest of the big economies, is still seeing savings disappear rapidly and real income growth move much lower. So even the U.S., and of course the global economy, is not safe from this recession risk. And so we can conclude here that the backdrop for credit has moved pretty sharply lower.
When we look at the cycle, there are three key indicators that we look at. One is the amount of debt outstanding, two is the access to capital markets, and three is cashflow and earnings, and I think all three of those are turning a bit more negative.
Continued supply shocks affect the system, and the savings rate has been drawn down, so I think consumption will go down just as margins are getting squeezed through higher input prices. So I think that earnings picture, which has been so resilient – and, in fact, one of the huge surprises of the pandemic – is heading lower.
Companies have to borrow, and when they find that more difficult, credit stress tends to grow. Lending standards are getting tighter, nominal rates have gone up materially. In addition to interest rates, credit spreads have risen at an extraordinary pace. So, for many companies, the cost of borrowing today might be three, three-and-half times higher than it was at the beginning of the year. Also, real interest rates are going up rapidly, so this is the cost of borrowing after inflation.
So I think what will happen as we move forward is a real attention on how bad the slowdown will get, but we’ve clearly priced in a slowdown from here. Normally at this stage in the cycle about 70% or so of the reaction of that pricing in of the future is already behind us. That does not mean that markets need to keep reacting; they’re forward looking as always.
For investors facing not only the volatility, but much lower prices, I think there are a few key things to keep in mind. Number one: don’t panic. I think decisions often made into weakness are backward looking. Position on a forward-looking basis, keep an eye on the signposts. One of the key signposts for me is that central banks, which are now panicking about inflation, that’s why they’re tightening policy.
It’s highly likely they overdo it, because their policy affects markets and the economy with a lag. So at some point as the growth slowdown takes precedence over inflation, I think there’s a good chance that central banks might panic in the other direction. The economy might still look bad in that phase of the cycle, but that’s often a great time to get investing.
I think in addition to keeping that one eye on the macro backdrop, you have to keep the other eye on security selection, picking those companies that are going to maybe thrive, but at least survive in this tougher economic environment.