Both stocks and bonds have shown resilience to start the year, posting solid gains despite a recent crisis in confidence in the banking sector, which has resulted in a significant amount of uncertainty surrounding the outlook for the economy, inflation, and the path the Federal Reserve may take. This article will take you through the good, the bad, and the ugly of this economy and the implications this may have for fixed income investors.
This economy has performed better than most economists have projected. The job market has remained strong, while wages have continued to trend higher, albeit at a lower rate than inflation. Investors have viewed this economy and market with a glass half-full mentality. As a result, both stocks and bonds have rallied to start the year and have brought a sense of optimism to a highly uncertain economic outlook.
Interest rates have moved lower as the economy has weakened, while stocks have gone up on hopes the Fed may be close to ending their interest rate hiking cycle. The debate of whether we will experience a soft, hard, or even no landing for this economy changed significantly as the recent bank failures at Silicon Valley Bank and Signature Bank have increased the odds of a bumpier landing.
The Fed remains in a tough and unenviable spot as they attempt to restore financial stability while simultaneously tackling inflation. As financial instability and the crisis in confidence fades away, inflation concerns and the longer-term implications for growth will come back into focus. If inflation remains stubbornly high, the Fed may disappoint the markets and reinforce their commitment to continue along the path of raising interest rates or keeping them elevated for longer than the market currently expects.
The recent bank failures highlight the cracks forming in the economy. This should result in weaker growth in the back half of this year, with the potential for significant downside revisions to earnings in the coming quarters. Our expectation has increased for a slowdown in growth as banks tighten credit standards which will reduce the availability of credit broadly. This, coupled with higher interest rates and persistent inflation, will likely raise the odds of a recession in 2023.
The recent stress in the banking system has created a wide range of potential outcomes and has increased the tail risks for the economy. A concerning aspect of the recent bank failures has been the speed at which they occurred. Advances in technology and social media have unfortunately contributed to the instability of the financial system. While confidence in the financial system is slowly being restored, the risks to the economy have increased as the probability of a recession and harder economic landing appears more likely. The challenge we see for investors is that risk premiums for the major asset classes do not currently reflect the potential downside risks to this economy.
THE IMPLICATIONS FOR FIXED INCOME INVESTORS
As interest rates have declined from their recent highs and yield curves have remained inverted, the bond market is indicating a recession may be on the horizon. The fixed income markets are pricing in the potential for one more interest rate hike by the Fed, with interest rate cuts anticipated in the back half of the year. We believe the market may be overlooking the potential stickiness in inflation and the Fed’s willingness to hold rates higher for longer. As a result, the markets may be getting a bit ahead of themselves once again, as a potential Fed pivot may be more difficult to come by in the absence of a more systematic banking crisis or a faster than expected decline in inflation.
Interest rates may remain rangebound in the near term, but we anticipate volatility to remain elevated as the Fed moves closer to ending their interest rate hiking campaign and considers cutting rates later in the year. As a result, the yield curve may begin to steepen as the year progresses, while risk premiums for the credit markets continue to underappreciate the risks to the economy.
Given the uncertainties surrounding this economy, the bond market could prove to be a safe haven for investors. The higher level of interest rates should give fixed investors a reason to be optimistic about bonds by providing diversification benefits for a well-balanced portfolio and a stable source of income. With yields in the 4.5% to 5.0% range on many fixed income offerings, bonds can provide much needed comfort for those investors worried about a harder economic landing.
The views expressed herein are presented for informational purposes only and are not intended as a recommendation to invest in any particular asset class or security or as a promise of future performance. The information, opinions, and views contained herein are current only as of the date hereof and are subject to change at any time without prior notice.
Executive Vice President, Director of Portfolio Management and Trading
Boyd Watterson Asset Management, LLC