A mild recession, surprisingly low volatility and real opportunities in fixed income

Unlocking Markets: a mild recession, surprisingly low volatility and real opportunities for fixed income

SPEAKERS

Mike Reed, Head of Global Financial Institutions, RBC BlueBay Asset Management; Mark Dowding, BlueBay Chief Investment Officer (CIO), RBC BlueBay Asset Management

Mike Reed  00:03

Good morning, and welcome to unlocking markets, a new RBC BlueBay podcast. This is the place where we will be looking to bring you experts across the firm providing opinions on the markets, global policy, sustainability, and macroeconomics, and how these feed into our investment decisions.

I'm Mike Reed, Head of Global Financial Institutions. And today I'm going to be talking to Mark Dowding, our BlueBay CIO, about a range of topics that we believe all investors should be thinking about right now, from the risk of a credit crunch and recession in the US to the likelihood of further rate hikes in Europe, plus the impact of global markets if or when Japan ends yield curve control. We will also discuss the state of investing in the UK. And finally, take a look at what it is in store for investors in the second half of 2023.

Welcome, Mark, we have a lot to get through today so shall we just dive in?

Mark Dowding  01:03

Sounds good to me, Mike.

Mike Reed 01:06

Okay, the Democrats and Republicans have finally agreed on a deal over the debt ceiling. And we have, according to Joe Biden averted economic collapse. Hopefully, investors can now return to focusing on economic fundamentals.

Given this resolution, can we take a positive view on risk assets, even though yield curves in both Europe and the US remain deeply inverted, which historically, is a good lead indicator for an upcoming recession?

Mark Dowding  01:35

Well, it's funny you bring it up Mike, it is one of those topics that is quickly forgotten, isn't it? Things like the debt ceiling will probably be something that resurfaces again, in a few years from now. I think to be honest; I don't think any of us really believed that the US was going to default, did we?

But in terms of your bigger question, which is the question around recession risk, I think the thing that we can see here very clearly is that as monetary policy starts to bite, we are seeing growth and activity in the economy, starting to slow. And we have also come to learn that there is a lot of lags with monetary policy as well, a lot of US households will have fixed their mortgages or ultra-low rates, and so, they've been relatively sheltered from high interest rates thus far in terms of the monetary policy tightening cycle.

As this continues to have an increasing effect, we do see economic activity slowing and we do think that the economy in the US is likely to slow to a standstill, effectively move to a technical recession around the end of the year. But all of this said, I don't think at the moment we'd be projecting a very ugly recession, like what we saw in 2008, to think back at that time. We are probably looking at an outcome where unemployment goes from maybe 3.5%, up to 4.5% maybe 5%.

Against that sort of recession, it's certainly not a disastrous world. And actually, with a lot of these thoughts priced into markets already, we have seen recently how risk assets have almost wanted to climb a wall of worry, to use a phrase that we often quote. This isn't to say that downside risks aren't there. But it would be perhaps a bit risky, betting the ranch on the idea that everything is going to get too ugly going forward from this particular point.

At the moment, around these sort of turning points in economic cycles, I think the other thing that is smart to say is that we should keep a relatively open mind. If we speak with central banks, they don't know what's around the corner, for them policy is data dependent. And I think the same is going to be true for us as well.

Mike Reed  04:04

Thank you very much. Yes, leading on from that we've seen an increase in defaults so far this year in 2023, which are now running at the highest rate since 2016. We witnessed the high-profile collapses of Silicon Valley Bank and Signature Bank in the US, as well as corporates such as Bed Bath and Beyond.

Given these data points, what are the reasons behind the rise in defaults? And are we at the start of a broader credit crunch?

Mark Dowding  04:31

Well, here I think the thing to emphasise is the defaults over the course of the past 10 years or so have been abnormally low Haven't they? Even through the pandemic, we saw low levels of default largely because we saw abundant government support on both sides of the Atlantic. We've lived in a world of abundant liquidity and very low levels of default rates through the course of the last decade. And in many respects, what we're starting to see a bit more of in 2023 is more of a normalisation in these sorts of credit events back towards more normal levels that we've seen in prior decades.

Also, what we're seeing here is very much a function of monetary policy doing its job. When central banks tighten monetary policy, in order to ensure and preserve price stability, there's a clear narrative that they want to tighten financial conditions. And as financial conditions tighten, effectively, it's like the tide is going out and you'll actually expose the weaker players when this is the case. I don't think there's anything unusual or abnormal to this particular point and I would say that we'd expect and project default rates to continue to rise somewhat further.

I think the big question here is whether we end up with a relatively benign recession, in which case, the level of defaults remains relatively contained, or are we going to be facing a much more ugly economic scenario, which could perhaps be the case, for example, if we saw further really bad news on inflation that caused the Federal Reserve to take rates to 6% or beyond or continue to adopt a very tight monetary stance for a very long period of time, but still we emphasise these as more risk events at the moment more than a central view.

As articulated in the last question, I think our central forecast at this particular case would be a relatively mild recession around the end of the year. And against that backdrop, I think, yes, there'll be headwinds for credit markets. But certainly, there'll be parts of credit markets that already price and discount a lot of bad news, like European financials, where actually we see banks performing very well against the backdrop of high interest rates leading to improvement in terms of net interest margins.

Not everything in credit is going to struggle when in this sort of context. But I do think that we're going to be in a world where sort of using more manager skill to actually pick the parts of the market you want to be invested in in credit, I think is going to be relevant, it is going to be more pertinent than it has been for the last decade.

Mike Reed  07:22

Yes, thank you. You mentioned European financials and the beneficial environment for them. Turning to Europe now, where companies have been much harder hit than those in the US by the increase in energy prices due to the war in Ukraine, and the EU's biggest economy, Germany has slipped into recession. But Christine Lagarde, President of the European Central bank (ECB), is still talking of higher interest rates to control inflation.

Do you think the ECB will carry on raising rates? And if so, how badly will this impact the European economy itself?

Mark Dowding  07:56

I think here we would say that when we ourselves meet with ECB, as with certain other central banks, they'll really emphasise to us that actually, price stability is so important as a medium-term driver of economic prosperity, it's really important that they see inflation coming back to target and they have been concerned that notwithstanding some progress on headline inflation, core levels of inflation continue to remain too high, so, there is a clear need, a clear imperative to get that level of inflation down.

All of this said, as economies start to soften, and you are right to highlight the fact that yes, we did see a technical recession, in Germany in the eurozone, at the start of this year, as these events come to pass, we do think that we're getting close to the top of the rate cycle now. Whereas in the US, we think our baseline assessment might be for one more hike to come, which will obviously depend on the data. In the context of the eurozone, we're looking for cumulatively, two more hikes to actually take the deposit rate in the eurozone to 3.75%, which is a level that we think rates will probably plateau at for the next six months or thereabouts before eventually coming down during the course of 2024.

That would be the trajectory that we're looking for but I think that at the moment, the ECB reaction function is relatively well understood. There aren't too many mysteries in terms of what the ECB is trying to do, and it does seem that on both sides of the Atlantic are after having made some mistakes, perhaps in terms of running policy, too easy for too long, notably in 2021 and early 2022, policymakers are now certainly can sort of catching up with where they need to be.

Mike Reed  10:01

Thank you. I guess one country where rates remain very low is Japan, where the Bank of Japan (BoJ) has maintained its yield curve control policy that has kept the 10-year bond yield below 50 basis points, which is hundreds of basis points below the equivalent rates in Europe or the US.

Do you think the BoJ will abandon this policy soon? And if so, how much higher will rates rise in Japan? And will this impact global markets substantially,

Mark Dowding  10:30

I think the BoJ will need to move off of this policy. Ultimately, yield curve control is a very accommodative monetary stance and in Japan, it was introduced in 2016, in response to really grave threats towards falling prices in deflation. But if we look at where we are in the world today, we now see inflation in Japan running north of 3%.

In fact, in June, we're going to see a big hike in electricity prices in Japan, which is going to push the inflation numbers higher. So increasingly, the BoJ inflation forecasts, I think, are being really questioned in terms of their credibility. And of course, the other factor here is that with very accommodative monetary policy compared to what we see in other developed economies, that's putting pressure on the yen to weaken. so yes, we can see that Japan is going to need to adjust its policy.

And I think that they should actually be rejoicing in this, the idea of yield curve control is not a policy that you want to run forever, it's more of an emergency policy that was introduced. Actually, the objective of the BoJ has been to get inflation to 2% on a sustainable basis, that's a target that we think that they have now attained and having hit that they should almost be in a position to exit yield curve control with their heads held high.

But even in exiting yield curve control, this is only the first of what would actually be several steps that they would need to take before we start talking about higher interest rates in Japan. We still haven't actually broached that particular topic at the moment. But there has to be a path towards normalisation because if there isn't, then my real fear here for Japan is ultimately they could find that they're not impervious to the laws of economics.

And although they haven't seen any proper inflation for the last 30 or 40 years, inflation could continue to surprise nastily on the upside. And if it does, there could be a need to tighten policy more abruptly, which I think given very high debt levels in Japan, that would clearly be very problematic if you needed to hit the brakes a lot harder at a later point in time. We do think that the BoJ would be well advised to get on with it and actually get on with it relatively soon.

Mike Reed  13:02

Now looking at the UK, where here we are witnessing stagflation with a combination of low growth and stubbornly high inflation.

What is your outlook for the pound and UK assets in general?

Mark Dowding  13:14

Yes, the poor old UK, I'd love to be more cheerful. I know that we're getting towards the end of our questions, I'd like to be finishing on a bit of a positive note with good things to say. But I do think that the macro backdrop in the UK is challenging. It's clear that the Bank of England, having had policy too easy a year or two back, is now caught between a rock and a hard place.

They've tended to be a more dovish, central bank. Inflation is now too high and even as inflation in other economies starts to drop more quickly, we actually see inflation in the UK stuck at higher levels. In fact, I think the government was asking the Bank of England to half inflation from 10% to 5% this year, I think they'll probably do that. But actually, getting it back towards 2% in the UK does seem to be a very distant prospect. And so, in the UK, arguably the Bank of England would need to do more if they wanted to do so.

But if they were to tighten rates more aggressively, then I think you really run the risk of cratering the housing market, and actually that could create financial ruin in as much as you're caught between a rock and a hard place. I think that the Bank of England is likely to err on the side of permitting inflation to overshoot higher and for longer than otherwise would desirably be the case.

I think as that plays out, I do think that this is going to be a factor that weighs on the pound. The pound has been holding up pretty well thus far this year. But we would sort of look at the pound on a medium-term view and think that the currency will end up taking the strain here, rather than the UK consumer. Particularly noting that we're likely to be heading towards elections next year, so yes, the UK is certainly an interesting macro story and one, that it is rich and opportunity for macro investors to prepare to take a view. It's a difficult one for sure.

Mike Reed  15:25

Yes, definitely a difficult one to call. Well, maybe here's your opportunity to finish on a more positive note. So far this year, US European and Japanese equity markets have all witnessed double-digit gains, whereas bond indices are only marginally positive year-to-date.

Do you think fixed income markets will perform better in the second half of the year? And which risks do you believe market participants are not focusing on sufficiently right now?

Mark Dowding  15:53

Yes, as we said earlier, equity markets have been climbing in that wall of worry, haven't they? And it's interesting, looking at the volatility indicator, the VIX, which, at the time recording, this is, is sitting at around a value of 13, which seems surprisingly low, and actually the lowest levels that we've seen since Jan 2020, before the pandemic struck us. So there has been this benign outlook, if anything therein we almost think that there could be some complacency, embedded within equity markets.

I do think that part of that complacency could be founded on the idea that everyone seems to have this belief that the recent past will repeat itself into the future. And therefore, we will see inflation going nicely back towards a 2% target. I would highlight as a risk that inflation could easily end up being stuck at 3.5%, which actually would represent more of a challenge, I think, for long-duration assets such as equities where we to see that.

But notwithstanding all of this, I think that one of the observations that you would have when it comes to fixed income, is that we have been through a period where there has been this upward pressure on yields from more restrictive monetary policy, we're getting to a point where that policy cycle is starting to turn. So even though we think we're going to be some way before we benefit from the tailwind of central banks, actually cutting interest rates, and the wind won't be on our back for a good while, I don't think yet, certainly the wind won't be blowing in our face nearly as hard.

That should create a landscape in which we're looking at better nominal returns in terms of a lot of fixed income sectors. I think that it certainly is interesting to be investing in fixed income again, I remember joking a couple of years ago, that high yield was fake high yield. I remember saying how can you be a fixed income investor when there's no income left to fix?

Life felt about as miserable as it would be being a Tottenham fan hoping that they go win a trophy. Right? It's, I know, Mike, I'm obviously that was a bit of a low shot, I should have I should have held back there. But now I won't, it's Spurs after all. But all said and done, there are going to be better opportunities better times ahead in fixed income.

And if you can pick the right spots, I think there are real opportunities to be making money in our asset class. And certainly, in a world where we no longer have some markets being dictated by abundant liquidity and central banks, effectively setting and controlling prices. I think it also is a great landscape to be an active investor. From that point of view, I think the future is looking bright and I'm pretty optimistic about the road ahead of us. Go on, you can say that Tottenham will go win the cup now.

Mike Reed  19:06

I would like to say thank you very much for joining us today, Mark. Yes, I think Tottenham's chances are maybe less rosy than fixed income is at this time. Anyway. If you're enjoying the show, please like and subscribe on your podcast platform of choice. We'll be back next month to discuss another interesting topic. So don't miss that. But in the meantime, goodbye and good luck out there.

RBC BlueBay  19:32

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