It's an 'on the one hand, on the other' economy

It sure is tough to get a read on this economy. Just a week ago, the prevailing view was a recession was looming, possibly as soon as spring. Then came January’s blowout jobs report. The ISM services index reading also surprised sharply to the upside the same day. Both splashed cold water on “a recession is imminent” talk. It’s hard to see growth abruptly ending when two dominant forces—a very tight labor market and its attendant rise in incomes, and a services sector that accounts for roughly three-quarters of economic activity—are going strong. Sure, the reports represented just one month’s data. But the magnitude of their out-of-consensus conclusions was compelling.

Yet in this “on the one hand, on the other” economy, the jobs and services reports also mean the Fed likely will stay on a higher-for-longer path. Additional rate increases could push the terminal rate above 5% before summer, with policymakers possibly holding it there through year-end. History tells us that, outside of sectors that are most sensitive to interest rates, such as housing, where the impact is almost immediate, monetary policy changes tend to hit with a long and variable lag. So, with the Fed’s tightening cycle only starting 10 months ago with a modest quarter-point increase (the four consecutive 75 basis-point hikes didn’t start until early last summer), the biggest negative impacts from the most aggressive rate hikes in four decades arguably lie ahead.

This “on the one hand, on the other” dichotomy is creating challenges for fixed-income positioning (equities, too). As forward-looking mechanisms, markets see a higher-for-longer Fed slowing the economy, maybe into recession, with all the incumbent hits to corporate and household finances that typically entails. This is why our fixed-income portfolio models remain largely defensively positioned, with below-benchmark exposure to investment-grade and high-yield corporate bonds. With risk markets rallying year-to-date, this pain trade has been, well, painful! Given the massive outperformance in the past few months, it’s fair to say credit markets are not priced for a recession, even a mild one.

To be clear, we are not looking to go further underweight in credit. Our already significant defensive positioning needs spreads (the yield gap with comparable-maturity Treasuries) to widen quickly to avoid a prolonged diminution of income that would come from being underweight credit. In fact, we’re already above-benchmark in our model allocations to emerging markets, in part because the yield is so high against relatively modest duration. It would take a severe widening in spreads to offset that carry trade. Moreover, a reopening China and weaker dollar represent excellent tailwinds for the asset class.

As for U.S. corporate bonds, a dramatically inverted yield curve, a rare contraction in the money supply and a higher-for-longer Fed all argue for an economic slowdown, if not recession. This would challenge profits and cash flow, push up defaults and generally weaken credit fundamentals, making it hard to justify adding exposure at current spread levels. On the other hand, corporate balance sheets remain healthy—a lot of debt’s been locked up at low rates. So, short an unexpected event (debt ceiling default, broadening Ukraine war), we think investors should be ready to add once markets price in this potential rough patch. We don’t think it has yet. The key is to be patient.