Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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Fasten your seatbelt as financial conditions enter red zone
Peter Garnry
Chief Investment Strategist
Summary: US equities have rallied lately on relief over the lack of Russia military success and mean reversion with flows rotating into technology stocks. With financial conditions tightening fast and Brainard's comments yesterday financial conditions and equities are soon entering the danger zone which could mean much more volatility and declining equities. In today's equity note we look at history and what it suggests will happen in equities when financial conditions tighten a lot over a short time period.
Brainard is signaling equities are galloping into the storm
The rally in US equities the past couple of weeks was a naturally relief and mean reversion trade following the declines from the war in Ukraine and turmoil in commodity markets. But the rally has likely ended and the rotation into technology stocks will reverse again with banks, value stocks, and the commodity sector at the receiving end of these flows.
Fed Governor Lael Brainard was out with a forceful message yesterday saying that reducing elevated inflation “is of paramount importance” as inflation hits low-income families disproportionately as they lack the substitution effect, meaning that if you are already buying the cheapest consumer goods you can substitute lower and thus you are hit harder by rising inflation. In addition, Brainard laid out the scope for much faster balance sheet reductions. The Fed is looking at a red hot US economy lately shown in the ISM Services figures for March hitting 58.3 and it wants to kill demand as the supply side of the economy cannot adjust fast enough to tame inflation. This means that financial conditions will tighten significantly over the coming months.
Based on data in the period 1971-2022, the 3-month difference in US financial conditions is negatively correlated with equity returns (tighter financial conditions means lower equity returns). The table below shows the mean equity return, mean equity return less inflation, and monthly equity volatility for different deciles of 3-month difference in the Chicago Fed Adjusted Financial Conditions Index. The current 3-month difference is 0.45 meaning that the economy is in the upper range of the 9th decile in terms of change in financial conditions.
The current tightening regime in terms of financial conditions is associated with slightly positive monthly nominal equity returns in the US, and slightly negative when adjusted for inflation. The monthly equity volatility is also substantially higher compared to more normal periods. But if financial conditions tighten more from here we will likely push into the 10th decile in terms of change which meaning financial conditions are tightening fast. Historically such as aggressive tightening of financial conditions is associated with significant negative equity returns, both nominal and real, and volatility is significantly higher than normal. Brainard signaled yesterday that financial conditions could tighten a lot more from here, so it is quite likely that we are entering the red zone with more trouble ahead for equities.
In terms of equity themes we are still overweight commodities, defence, cyber security, logistics (although the falling container rates are challenging our view), and renewable energy (tailwind from EU energy independence). We are still underweight e-commerce, bubble stocks, China, and NextGen medicine. Semiconductors are increasingly getting weaker despite pricing power in the industry and if sentiment is not coming back soon we will turn negative on this theme as well, and general it is not a good sign to see weak semiconductors as it is a highly cyclical industry.
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