We’re Betting On Cycle Longevity
Recent curve flattening has market participants worried that the longevity of the cycle is being called into question; we’re taking the other side
- Recent bond market curve flattening has triggered concern from market participants on several fronts; is inflation stickier than previously expected? Is the labor force participation rate permanently impaired, thus driving a tighter labor market than formerly thought? Will the Fed tighten excessively in response? If so, should markets assume a shorter business cycle?
- To the first question we continue to say unwaveringly “yes” as we have long since held the view that underlying fundamental drivers of inflation have been accelerating over the course of 2021 despite our expectation that “transitory” supply chain issues will eventually subside. To the last question we continue to say steadfastly “no” as the economics of the consumer – particularly in the U.S. – remains very healthy amid low leverage levels, impressive wage growth and strong employment gains (aside from the Delta-wave induced slow-down over the summer).
- To that end, we do not view recent curve flattening as indicative of anything other than noise and bond market volatility. In fact, S&P 500 returns tend to be robust following curve flattening episodes outside of recessions (as depicted below). This brings the following maxim to mind… “the market has predicted 10 of the last 5 recessions.”
Source: MAST, Bloomberg L.P., S&P 500 returns measured from 01/01/07 - 08/31/21; top quintile curve flattening reflects rolling 30 day periods where 10Y UST minus 2Y UST flattens at least 12bps.
Updated Perspectives – In Detail
- Level set – what are our business cycle and growth cycle models telling us? We remain in a Low Risk Expansion according to our Business Cycle Regime Model1 which indicates that levels of growth remain elevated globally and particularly in the developed world. Our Growth Cycle Regime Model2 continues to point towards a Deceleration Regime, indicating that growth is slowing. When we piece this together, we’re left with slowing growth from high levels. In this type of a backdrop, equities have historically outperformed both duration and credit; U.S. equities have historically outperformed the rest of the world, and longer duration growth equities have outperformed value cyclicals. Within fixed income, duration has historically outperformed credit. This reflects our current posturing in portfolios, for the exception of duration where we remain underweight.
- What are our equity valuation models telling us? Our equity risk premia model – which values the S&P 500 relative to underlying interest rates – currently assumes high single digit returns for equities in the next 12 months. This is entirely due to earnings growth as we expect multiples to compress from current levels. We also think that market consensus is far too low on EPS growth for 2022 and 2023. We believe this is the case for the following reasons: 1) many companies have stopped issuing EPS guidance due to the complex nature of forecasting with COVID in the background, 2) the companies that are issuing guidance are being very conservative as concerns remain around future COVID waves, and 3) we believe the market is significantly underestimating earnings leverage (i.e. the amount earnings grow for every unit of sales growth). We therefore continue to use earnings numbers in our valuation framework that far exceed the Street.
- What is our U.S. Treasury model telling us? Based on our current forecasts which include probability weighting ~35 different rate hike paths over the next 30 years, we believe the fair value for the 10 year UST yield 12 months from today is approximately 1.65%, slightly above current levels. We estimate that the Fed will indeed hike the Fed Funds rate one time in 2022 as a result of reaching maximum employment and expectations for inflation to remain above 2.0% for quite some time. We believe the Fed, however, will hike slowly and cautiously as the FOMC is sensitive to the fact that the tools at their disposal when near the zero-lower bound are very asymmetric in nature – meaning, they can more easily bring inflation down by hiking interest rates than they can lift inflation by lowering interest rates. Therefore, we see the odds of the Fed hiking rates aggressively to the point of causing a recession as very low. We also believe that there are three drivers of inflation at the present time: 1) transitory supply chain issues, 2) cyclical fundamental drivers, and 3) secular disinflationary drivers (predominantly demographics, technology and elevated global debt levels). We anticipate that the first will wane over 2022, the second will likely continue to accelerate, and the third will keep a ceiling on inflation longer term (although inflation will likely persist above 2.0% next year). We believe the third driver will keep long run inflation expectations reasonably anchored close to 2.0% and therefore keep interest rates low relative to prior cycles.
- Where does this leave us? We are more broadly of the view that the cycle will continue from here, corporate earnings will grow above expectations, interest rates will remain low, the Fed will begin to hike in Q4 of 2022 but move patiently and cautiously, the economics of the consumer will remain robust and drive strong levels of consumption, and future COVID waves will have less of an impact going forward. We also believe that the worst is behind us for China as growth bottoms out following the current COVID wave and we begin to see some fiscal and PBOC support. We therefore retain our pro-risk positioning in portfolios at the present time. We do, however, anticipate that growth will slow more aggressively in 2022 and that at some point in the coming months and quarters it will make sense to reduce risk in portfolios, but we do not think that time is now.
1The Business Cycle Regime Model leverages the Multi-Asset Solutions Team’s Business Cycle Index to determine if the economy is “Early/Mid Cycle” (akin to the MAST Low Risk Expansion Regime), “Late Cycle” (akin to High Risk Expansion Regime) or “Recession” (akin to Contraction Regime). This model tends to look out ~12 to 18 months.
2The Growth Cycle Regime Model leverages the Multi-Asset Solutions Team’s Business Cycle Index to determine if economic growth is accelerating or decelerating. This model is relatively more tactical and tends to look out ~3 months.
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The views expressed herein are those of the Harbor Multi Asset Solutions Team at the time the comments were made. They may not be reflective of their current opinions, are subject to change without prior notice, and should not be considered investment advice. These views are not necessarily those of the Harbor Investment Team and should not be construed as such. The information provided is for informational purposes only.
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