Global Perspectives: Dissecting the cycle

Adam Hetts: Welcome back to Global Perspectives. It’s time for another update with John and Jenna. John Pattullo and Jenna Barnard are, of course, our Co-Heads of Strategic Fixed Income here, at Janus Henderson, and they’re always good for a sober and sometimes sobering assessment of the global economy. And a little bit of trivia for our listeners is that John and Jenna were the first ever guests on Global Perspectives, and that was almost exactly three years ago, in July of 2020. Now, it’s July 25th, 2023. So, it’s always great to have them back.

And so, John and Jenna, let’s just get right into it. After the last episode we did, which was late 2022, the market went into 2023 heading towards what was supposedly the most anticipated recession ever. Now, all of a sudden, the S&P is within arm’s reach of all-time highs, US and European earnings are at or near peaks, and inflation in the US is almost back to a two handle. So, investors seemed to have shrugged off all that recession risk but the question is has anything important about the global economy actually changed? Is there anything that could actually warrant all this optimism? Jenna, we can start with you.

Jenna Barnard:  I think from an absolute perspective this is one of the weakest global growth environments we’ve had in the last 20 years outside of the GFC and COVID recessions. I think really the optimism is relative to what the lead indicators and the long lead indicators were saying and continue to say.

Those lead indicators, the Conference Board obviously has a well-known one in the US. There are a mix of monetary indicators like yield curves, monetary aggregates. You could do rate of change of bond yields, housing, building permits, manufacturing cycles. There is such a pervasive, persistent and pronounced downturn in long leads and lead indicators that we look at.

I think the coincident indicators just running at this very low growth/stall speed rate, that is a relative success. That is a relative success. And the question really is whether those coincident indicators are going to bottom out here at this low, stall speed level or whether you are going to get a recessionary dynamic that spirals downwards and takes the global economy into a hard landing.

But it is worth noting that, as bond investors, this level of growth is not a problem for bond yields. When we track, for example, in the US economy the six coincident indicators that the NBER use to define recession, I think they are running about 1.4% growth year-on-year. That is the kind of level they were at in 2013, 2016, late 2019 and bond investors will remember those periods where ten-year bond yields in the US were around 1.5%-2.0%.

This kind of low level of growth, this kind of stall speed, some economies in the developed world are running zero growth, like the UK, eurozone, some are slipping into technical recessions, like New Zealand, but broadly it is just very, very stagnant. So, relative success compared to the lead indicators but it is in the grand scheme of things pretty disappointing and obviously the big news this year is that the China reopening was not the excitement it was expected to be. So, it just remains very stagnant and very slow.

The problem for bond investors obviously isn’t growth, it is core inflation, the ultimate lagging indicator, and how that gets squeezed out and how it follows these headline inflation collapses that we’re seeing on the back of base effects and commodity prices coming down. So, that would be my summary, Adam. It is not great. If we were sitting in any other year it would be pretty disappointing but relative to what we see in those lead indicators it feels good.

John Pattullo: I think I would add, equity markets are quite narrow and quite thin and it has all been P/E expansion, Adam. It is not justified by current earnings growing or even the forecast of future earnings growing. I think the long and variable lags that everyone talks about in monetary policy, a lot of them haven’t hit yet because the bulk of the tightening broadly happened this time last year.

So, we actually think there’s a lot more tightening already in the pipe which hasn’t washed through the economy and it’s pretty hard to see an aggressive earnings per share recovery justified or even anticipated in the stock market when you know there is going to be further tightening in the economy.

The credit markets and equity markets have been firmer than we have anticipated and I think a lot of people are struggling to explain why equities are quite so strong, given this outlook, and credit markets have rallied on the back of that. So, it seems priced for perfection I think, risk, from here in our opinion.

Hetts: If I were to try to paraphrase some of that market narrative that has driven the equity optimism, there’s some optimism about inflation falling off, which it has in a sense, and then rate cuts coming sooner than expected, which maybe is possible. We’ll talk about that later. So, in that there is a way to justify some of that multiple expansion and equities are forward-looking markets. They’re already looking forward through the valley of potential recessionary weakness into the supposed 2024 recovery in earnings.

But I feel like the big caveat the market doesn’t want to address is what you just said about those long and variable lags of all these hikes and they’re not just in the rear-view mirror. That seems to be the narrative, is we survived it, we got through it and hikes are almost over, so now it’s just upside.

But what does that lag look like? Because I think that might be one of the most important things that is not being discussed. What’s the sequence, what’s the timing if we’re at this point, nearly a year out from a lot of the hikes? How long before the actual impact of that really filters into the economy?

Barnard: That is a great question. If you take classic sequencing, which I think was your first questions, it is volumes declining. We’ve seen real retail sales in places in the US but also elsewhere, I think we’ve had five consecutive negative prints now on real retail sales. Industrial production peaked in Q4 last year. So, we’ve seen volumes in the real economy declining, orders declining, but hiring and employment has held up. So, that implies a productivity decline, margins compression.

We’ve seen hours worked declining. That’s a lead indicator of employment. You’ve seen temporary employment contracting. That’s the easy bit for companies to get rid of. Then, eventually, it feeds through into layoffs, initial claims, continued claims and then ultimately nonfarm payrolls and unemployment.

So, I’d say that if you’re thinking about classic sequencing, you’ve seen the early signs and the one real laggy experience this cycle, even compared to inflationary recessions where employment always lags, is the labor market. And if you just take manufacturing as an example, ISM manufacturing today in the US is at a level of 46. That is very weak. Even in soft landings that has been associated with manufacturing job losses of 200,000, in recessions anywhere between 500,000 and 800,000, and to date we’ve only had 25,000 gross manufacturing job losses.

So, there is a disconnect here when you’re thinking about sequencing of the business cycle and a really unusual lag, and that is in the employment. So, I think if you’re going to debate whether these lead indicators are giving a false signal this time – [and] it is very rare for them to give a false signal – it would be in that employment component.

The problem is every lead indicator of employment that we look at, overtime hours, voluntary versus involuntary, part-time work, temporary employment, they’re collapsing and they continue to collapse. We’re not seeing any uptick in lead indicator employment, so rationally, logically, we should expect employment to really soften and see some negative nonfarm payroll prints in the second half of this year.

You’re seeing that in other countries, a collapse in vacancies in the UK and parts of the eurozone. Same phenomenon with temporary workers. So, it is lagging but it is there and we think it will come in the second half of this year.

That’s the way we think about it and we’re thinking about how long the lags can be between lead indicators, coincident indicators, lagging indicators, looking at inflationary and non-inflationary recessions, soft landings, hard landings. I suppose other people might attack it in a different way and they might look at lags for monetary policy.

If you approached it from that perspective because central banks were so late to start hiking rates, so, so, so late this cycle, the lagged impact of monetary policy would only imply employment turn in the second half of this year. People who followed that process always thought the employment weakness and the real growth weakness would be a second half 2023 event.

That gives you a feel and obviously there is always a risk that it is just completely different. This isn’t a business cycle, none of these lead indicators work and we’re in a totally different paradigm. We’re obviously not in that camp but that gives you a feel. Every cycle is different. As you said, the lags are variable but we’re seeing very consistent evidence across lots of developed market economies that services are beginning to slow and the employment, the labor markets are cooling very, very fast indeed.

Pattullo: I would only very briefly add, I don’t think life is that easy, Adam. It is literally a bit like being in the shower, the old analogy, and you’re getting a bit frustrated the hot water is not coming through and you turn the hot water up, nothing happens and next minute you’re scalding yourself. And that’s kind of what the central banks have done because they’ve got increasingly more hawkish the later they’ve gone and a little bit panicky towards the end of this thing, even though progress was being made.

But they and markets lack patience and then to get this kind of immaculate disinflation that everyone is talking about where you maximize or you optimize for inflation and then unemployment month by month by just controlling monetary policy, I just think that is a massive ask and, in my opinion, virtually inconceivable to solve for perfectly.

Hetts: And particularly alarming, Jenna, you used the word collapse a few times. As far as these indicators, just two more questions on indicators then we can move on. You were talking about collapse. Is there anything that is almost looking unprecedented about this cycle and what these indicators are telling you about the severity of the potential drawdown or recession or, maybe said differently, if it is not unprecedented, what precedent or comparisons are in your mind as far as other historical recessions, just given the severity of the indicators right now?

Barnard: That is a good question. When we use really long lead indicators to give us direction of travel for six to 12 months and they are all a function of monetary policy, that’s monetary aggregates, rate of change of bond yields, housing, very early indicators of housing cycles and the yield curves. Those have collapsed is the right word and the depth of the collapse is at a level that we have seen before but we last saw it in the early 1980s, and that is logical. It gives you a sense of what the central banks have been doing.

When we look at lead indicators, service, manufacturing, construction, other elements here, not just monetary aggregates, they are in deep recession territory, the kind of depths we got to in the early 2000s, early 1990s, so proper hard landing depths. That gives you a sense of the lead indicators and then, as I said, the coincident indicators are just at stall speed. I wouldn’t say it is completely unprecedented or there is something completely different here. It is just the lags feeding through to coincident indicators and that is where the debate really is.

Hetts: And when these are collapsing historically, I think John you said earlier, potentially maybe the market is right. Small chance that there are some false indicators or false flags out there but what kind of predictive power, if that’s a fair question, when you’re seeing these types of collapses? Is this historically typically an 80-90% predictive power that there is a recession coming?

Barnard: There are false signals. 1967 would give you a classic false signal from the yield curve and some other lead indicators but they are relatively rare, so it is not something you could bank on. Then, you can crosscheck it. Instead of using top-down macro lead indicators you can use bottom-up, so something like real corporate revenues, which is quarterly data that comes out from national accounts. That has turned negative now. That really hasn’t given you a false signal.

So, when you marry up a breath of indicators, top-down, bottom-up, it would be tricky not to have hard landing but, as you said, you never know. It is not 100% in advance, but it is looking pretty tricky. It would have to be employment holding up. For me, that is the difference between a soft and a hard landing, the risk assets. I think for central banks that is really that employment component and so that, I think, is going to determine how these coincident indicators move in the second half of this year.

We look at those six NBER coincident indicators in the US, they are all consistent with recession when looking at it from a year-on-year growth rate, apart from employment. Things like real consumer spending never really goes negative. Services don’t really contract in terms of job losses other than very severe recessions like ’08-’09 but employment does still look relatively strong, so that, for us, is the dividing line between soft and hard landing.

Hetts: Then, that lumps into my last question on indicators, I promise. So, what’s the cheat sheet for listeners then going forward? As far as indicators, are they going to be keeping an eye out for certain headlines that start to inform them on hard landing versus soft landing versus immaculate disinflation? What is it? It sounds employment-related but specifically what do you think listeners should keep an eye out for?

Barnard: Again, it is just tracking the sequencing of the employment indicators, vacancies, voluntary versus involuntary, part-time work, hours worked. Then, initial jobless claims is your classic lead indicator. Nonfarm payroll, your classic coincident. Unemployment and wages, your classic lagging indicators. In inflationary recessions and employment, you don’t really get the first negative nonfarm payroll until halfway through the recession. So, if we look back to the 1970s and early 80s employment can be laggy even as a coincident indicator once you’re in inflationary recessions.

Those would be the indicators that we’d look at from a macro, sovereign bond perspective. Then, if you are to ask me what is the one macro indicator that credit really cares about, credit spreads, that lights out, it would be initial jobless claims. If you start to see that really moving with some momentum, some ferocity, credit spreads always take notice of that. So, from a risk asset perspective the difference between a hard and soft landing would be some real momentum in those initial jobless claims, that lead indicator.

Hetts: So, for better or worse, getting sort of simple, it’s all about employment at this point, isn’t it?

Barnard: Yes, 100%. Well, we have talked about core inflation but, yes, it is core inflation but from a growth, hard/soft landing it’s employment, absolutely. That is what looks odd this cycle. That is what looks lagging. That is what central banks use to characterize the growth environment and obviously inputs heavily into their inflation outlook, given their wage Phillips curve frameworks that they use.

Hetts: So, then, let’s get into that trajectory on core inflation as you two see it and then, maybe as a link to that, also how that ties in with market predictions for a rate cut coming as soon as this year and how that plays with your inflation expectations.

Barnard: From a headline perspective, US is ahead in this inflation cycle. Headline inflation in the US peaked in June of last year. As you mentioned, Adam, it has just collapsed down towards to just under 3%. Europe and the UK you had headline inflation peak in October 2022 because you had the additional natural gas surge in Europe and elsewhere it peaked in Q4, places like Australia.

So, I think all eyes really are on the US and how quickly the US can squeeze out core inflation and the first half of this year was really disappointing because you got this kind of plateau in core inflation. You had month-on-month prints running at 0.4%, even 0.5% month-on-month and it has not been this nice, even, linear squeeze out of core inflation.

What it looks like you are going to get is a big step down and we just got that step down a few weeks ago, so 0.2% month-on-month prints such that actually by the end of this year the Fed’s 3.9% core PCE forecast is looking very high relative to market expectations of around 3.5%. So, it has been a slightly frustrating first half of this year. All eyes are on the US where you’re seeing quite pervasive disinflation, which is going to spread through to rents, to used cars in the coming months, based on what market prices have already done.

Then, the question is these lagging economies. We’ve only seen core inflation really start to turn in Europe back in March and potentially in the UK in May based on last week’s print but there was a huge crisis of confidence in UK monetary policy as a result and core inflation is such a lagging indicator that it is going to take time and that is really going to dictate the debate about rate cuts.

And if core inflation does surprise the Fed to the downside, which is looking increasingly likely, whether they then need to just mechanically adjust nominal interest rates to keep the real interest rate at the same level. So, if inflation comes in lower you’re going to have to adjust your nominal interest rate down by a similar amount to keep that real level at the same kind of level.

So, yes, debate, not sure end of this year but certainly Q1 to Q2 next year, even in this benign disinflation story, so you get the soft landing in growth and core inflation continues to follow the path that is expected and you can start to debate rate cuts potentially around spring of next year. Then, we’ll just have to see, again, how that process plays out in Europe. What is the analytical value of core inflation when you’ve had such a pervasive, such a defining energy shock, food shock, as you had in Europe?

Does core inflation just collapse along with headline in the way it surged? There’s a lot of uncertainties and we’re going to find out but the US is absolutely at the forefront of this whole debate, given how it leads in this inflation cycle. I could go into more detail but that gives you a feel for how it is looking.

The only other thing that is worth mentioning sitting in China or looking at China, there’s now a debate about deflation, given that headline CPI is around zero, PPI is deeply negative. And that is quite ironic because two years ago we were being told that China was going to drive structural inflation because there wouldn’t be enough workers in China given demographics. And, as we sit here today, actually the debate is about whether China is going to export deflation around the world.

So, these inflation debates they move. The structural inflation debates or stories tend to be extrapolated by what is going on in the short-term and it could feel very different in the back-end of this year if this core inflation continues to pan out the way it is looking like it will. It is very quick headline disinflation, one of the quickest in the last 100 years, much faster than we saw in the 1970s, even faster than the inflation episodes in the 40s and 50s.

Now, it’s just a question of waiting for that lagging indicator of core inflation to see how that will squeeze out in the second half of this year. So, frustration because it took a bit longer, there was a bit more of plateau in the first half, but ultimately the signs are positive and that is encouraging for the rate cut debate next year.

Pattullo: And also inflation profiles can be reasonably symmetrical, Adam, as well and I think we’ve made massive progress here. Arguably, some of that early inflation was supply side, bottleneck stuff and then arguably the later stuff was more demand driven and that had to get contained and was driven down by the interest rate rises, which I think are now working.

And to be fair, we’ve had some false pivots as well. I was just remembering last August we had a false pivot just before the Jackson Hole very hawkish piece by Powell and then we obviously had the false pivot with SVB (the bank), but at that time we hadn’t made enough progress on inflation and now we have.

We’re recording this on Tuesday before the Fed decision tomorrow on the 26th for listeners, but now that is a given. But that’s not much more priced in in the market than that and then it is reasonably flat. Then, the market is discounting rate cuts probably in summer (2024). We actually think rates could be coming down faster than that because historically rates haven’t plateaued for that long in inflationary environments.

We’re more bullish on inflation coming down faster than the market and obviously if you don’t bring rates down as inflation comes down, you actually tighten financial conditions. So, I think that narrative could change quite fast. Tougher in Europe and even tougher in UK, which still has quite a lot priced in, in rate rises going forwards. But we’ve made an awful lot of progress here. Super core inflation is making good progress and, as Jen said, I think in a year’s time, if you think about those lagged effects of monetary policies washing through the economy, I think we could well be discussing disinflation. And where is the next growth stimulus going to come from, which is fascinating really?

Hetts: We can fast forward that next growth stimulus conversation. Are either of you capable of playing devil’s advocate in this sense of rationalizing the market’s optimism given the historic tightening that is driving the slowdown? Is there any way it can reaccelerate without further slowdown?

Pattullo: I was reading some research today and it is just awfully hard to get an uptick in activity in earnings per share without the Fed cutting rates. If the Fed cuts rates, the economy then starts to pick up and the market obviously anticipates that but, until you get there and until some of these historical rate rises are washed through the economy, I think it is pretty hard.

Having said all of that, maybe we get a solution to the Ukraine war. Maybe we get some sort of fiscal boost around the States and Europe maybe. Maybe the central bankers do a fantastic job optimizing bringing interest rates down and we sail on regardless. Maybe. We’re not dismissing it.

I think the probability of that is remarkably low and the market is obviously priced for that at present. So, I wouldn’t get too bullish on the narrative from here given what is priced in. But as I said earlier, I just think life is not that easy, especially given the massive sine wave we’ve had post-COVID. I think it is a tough ask. Jen might have a more sensible answer to some of those things, but it is a tough one.

Barnard: I think you can have a debate about the manufacturing cycle, whether it is bottoming, particularly with these ISM PMI manufacturing at mid-40s or even in Germany in the high 30s. These are kind of levels you would expect bottoming out to happen. We’re not seeing a sharp reacceleration or hearing of a sharp reacceleration, but you could have a debate about inventory cycles and whether those might be coming to an end.

The problem with that is then the lagged impact of rate rises just starting to feed through the economy. You see it in bank surveys, credit creation, potentially labor markets, as I mentioned. I think in manufacturing you can have a debate, but it feels to us like it would be a long bottoming process, not a sharp reacceleration driven by stimulus or anything else. So, that would be where the debate would focus and then it’s just a question of whether those lagged impact of rate rises and incredible aggressiveness of central banks around the world then starts to feed through as typical lags would dictate.

Hetts:  Good job playing devil’s advocate, by the way. I had low expectations, but that was good.

Pattullo: We try our best. We’re miserable bond people. That is the problem.

Hetts: The tiniest of green shoots there. There was something. Then, from an asset class perspective, if we put all these pieces together, sovereigns mostly range-bound recently, credit spreads have only tightened. So, how do you feel about the fixed income opportunity set, right now, from the market’s perspective given that economic backdrop? Then, maybe you can organize it. I don’t know if it is helpful to rank sovereigns, versus IG, versus high yield. Maybe compare that across regions. Very loaded question, so take your time, however you want to unpack that.

Pattullo: It is an obvious point, but you raise cash rates to compete with other asset classes and that inverts the yield curve and that slows down the economy and that makes people sell risky assets and deposit money in cash. I know that is stating the absolute obvious but that is exactly how it should work and how it is working.

Cash is a good place to be today, but I think some clients and some people forget that is fine, you might stick it on deposit for one year or two years but when that deposit matures, what is that reinvestment rate in two years’ time. I think some people forget that. So, on the back of that you don’t want to miss potentially quite a bit interest rate duration rally when we are now at arguably the peak of interest rates being priced into the market in the States.

So, our rank really is sovereigns, then IG, then high yield. High yield only performs in a soft landing whereas IG and cash, sorry, and investment grade obviously perform pretty well in a soft or hard landing. In addition, it is hard to argue against any front-end credit with reasonable credit quality. That includes cash but also front-end investment grade because you would expect yield curves to steepen up a little bit as we get into the recession and so on. So, yes, it is a pretty textbook rank, I think. Cash for a while, push it into sovereigns. We like IG and high yield is your wildcard, subject to getting a soft landing or not.

Hetts: With high yield furthest down that rank list, has the level of high-yield spreads being relatively tight, is that an analog to equity markets? You’ve had this optimism/euphoria and that has just driven risk assets and driven the bid up there or is there something else about high-yield markets, is there something about supply and demand outside of just sentiment that is driving spreads tighter?

Pattullo: That is a good question. The short answer is yes. It is just an analog to risk and systemic risk in equity markets. The more nuanced answer, and these are all valid arguments, but I don’t think they’re that material, the quality of the high-yield market is better. There’s more BBs, they’re broadly less cyclical, they’re in better sectors, they are less levered and, you’re right, there is a negative net supply, so there’s no new net issuance coming into the high-yield market. And all of that would suggest the technicals are pretty strong.

Another interesting thing the listeners would be aware of is the private credit markets and leveraged loan market have taken a lot of the supply away from the public high-yield markets and it has gone off to private credit and leveraged loans. So, the technicals are, frankly, really supportive.

Having said all of that, if you get an earnings recession, systemic risk rises and high-yield spreads widen, maybe not as much as they should or some of the brokers have suggested, but maybe the quality of the market is 10-20% better than it was historically. But I personally don’t think that would compensate. If equities come off, high-yield spreads balloon wider.

Hetts: That is helpful. Then, have we missed anything? Anything else you’d like to advise listeners to be watching? We talked about economic indicators, what the cheat sheet there is or the stack rank of asset classes within the fixed income universe.

Barnard: The one silver lining in this whole situation is the inversion of the yield curve means that as a credit investor you can get really attractive yields without taking on either very subordinated high-yields or financials risk or stretching out for duration in credit. So, you can get defensive and still pick up yields.

Similarly, if you looked in the US at AAA agency mortgages versus investment grade credit, so that’s a BBB asset class, they have very similar yields to asset classes that behave very differently in a soft versus hard landing scenario. You never want to get defensive too early to give up the carry but there are ways of expressing it in credit markets today that just mean from a relative value perspective you don’t need to think about high-yield or that area of the market.

Pattullo: We call it stretch, Adam. You don’t have to be daft. There’s plenty going, very competitive all across, and it’s very competitive in real terms as well. Real interest rates are positive, which is unusual.

Hetts: All right. Well, thanks again, John and Jenna, and thanks to our listeners for joining. As always, the views of Janus Henderson’s other investment teams and thought leaders are freely available within the Insight section of our website. If you haven’t already, you can find us on Spotify and iTunes, so please like and subscribe and we’ll look forward to bringing you more Global Perspectives soon.