Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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The models are broken
Quarterly Outlook
Steen Jakobsen
Chief Investment Officer
Summary: The market is trying to get back to the pre-Covid and pre-war times, but that model is broken. A new dawn is here and the financial world needs to adapt.
A famous quote says: “If it is not broken, don’t fix it” which seems to be the operative model of all central banks and politicians since the 1980s, with each market cycle bringing a rinse and repeat of the prior cycle policy response of extend and pretend and releveraging of our already debt-saturated economies. What it should read is: “Why does it keep breaking, and breaking worse after every time we try to fix it?”
This is exactly what this quarterly outlook is about. We start the year with the market busy trying to get back to pre-Covid, pre-war in Ukraine standards for the global economy and a new massive leveraging up as interest rates ease and not least, as inflation hopefully fades.
We think this is an entirely misguided premise for what the world needs. We simply think the models are broken. The same models that didn’t see rising inflation are now predicting a peak in inflation, a peak in Fed rates and a general return to higher asset returns without dealing with the underlying crisis from energy shortages (in both baseload and lack of investment), and the move to diversify and deglobalise supply chains. From a mostly OECD country perspective, there’s also the rise of dangerous new potential trade and financial alliances (Russia, China, India and Saudi Arabia) and not least too low productivity to bring real growth or reduce inequality.
The same model also was busy through H2-2022 to talk about the 100 percent likelihood of a US recession! As 2023 gets under way, it’s even money between a ‘soft landing’ and a shallow recession scenario. Models simply don’t work. What has transpired in 2022 was that the excess demand came down but didn’t collapse, the supply function remains below the demand and hence there is real risk of medium- and long-term inflation failing to reach the magic 2 percent, or even 3 percent, but instead ending up at more like 4 percent.
This means a need to focus on the real economy, the tangible things we can touch and see as opposed to the intangible digital economy. Today in the S&P 500, 90 percent of market value is in intangibles. Ninety percent! This means the real economy is too small for the ambitions of fiscal and monetary policy, the green transformation and even the power-hungry digitalisation ongoing globally. We simply need to build more infrastructure, create cheaper and more environmentally friendly energy and not least become more productive.
Many pundits consider the present supply scarcity and the overall constraints as a hindrance for growth potential in the economy and return on assets. The reality, however, is that we have the highest propensity to innovate and change when we are under the most pressure. We believe that the higher marginal cost of capital, the constraints on available energy, and the inability of central banks and political systems to allow markets to have true price discovery will lead to a complete break with the old models, but a positive one for moving forward. The negative break came in 2022 when both bonds and equity fell. In 2023 we have new fundamentals.
The peak in policy rates is close – not here yet but closer. The consumer continues to spend money as they draw down the stimulus money from the pandemic and savings, and sometime in 2023 they will move into credit financing. We have full employment. Financial conditions are easier than when the Fed starting hiking in 75 bps increments in June of last year. And importantly, China has pivoted away from its zero-Covid policies and some of its crackdown on the private sector.
We consider President XI’s reversal on zero-Covid policies, tech companies and not least housing critical for the rest of 2023. Last year China imported less energy, had low demand in commodities and ran the economy at maximum 70 percent of capacity. Now China leadership realises that the last decade of slowly decreasing private initiatives has left the economy weak and exposed. This will mean renewed, massive support for fiscal spending, much of it in infrastructure, support for housing credit, expansion of state-owned banks’ balance sheets and a reopening of the economy.
This may be the single biggest event in 2023 having happened before this publication goes to print. Pull out a chart and observe what China’s scaled-up expansion did to the global economy in 2003 (post-WTO entry), 2009 (post-GFC crisis) and 2016 (currency devaluation). We expect the magnitude of China’s credit impulse to match 2007-2009 as the three-year lockdown will mean China will be fiscally expanding longer and deeper than normal.
Q1 is likely to be dominated by the fight between a soft landing and recession. For now, the soft landing probability is rising fast, and the recession probability is falling. We see this and trade this as long risk assets in Q1, but at all times we remind ourselves that nothing has changed fundamentally. We are long energy, long deglobalisation as the economy is running on very easy financial conditions. This means by H2-2023 inflation will resurface, growth will surprise to the upside globally, but mainly in Europe and the US, and the Fed will be forced to begin hiking again after only a short pause (not set for a long series of cuts starting later this year). This will echo the path of Fed Chair Volker in 1979 to 1982.
The models are broken, but before we change, we will likely see the market pricing a new round of extend and pretend in Q1.
Safe travels,
Steen
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