Long ReadJun 9 2023

What is the outlook for bonds amid a potential US recession?

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What is the outlook for bonds amid a potential US recession?
The New York Stock Exchange at Wall Street. (travnikovstudio/Envato Elements)

The US recession is still a way off, but the economic outlook remains fragile. 

Investors are being compensated for the wait as bonds continue to have a more attractive risk/return profile than equities.

Can the recession be avoided? 

On the surface, the case for recession seems simple and straightforward: a strongly inverted yield curve suggests that the US Federal Reserve in particular has tightened the monetary policy stance too much.

A steep decline in oil prices points to weakening demand; tightening lending standards will choke off economic activity; and the contraction of the M2 money supply may be a sign of a weakening economy.

Meanwhile, demand for credit has collapsed in response to higher interest rates.

'This time is different?' Probably not.

The regional banking crisis will exacerbate this situation, especially for small businesses that rely most heavily on this channel of credit access.

Historically, a decline in loan demand and a tightening of lending standards occur only a few months before or during a recession.

And yet economic growth in the US for the first quarter of this year was actually revised upward recently.

The US labour market remains strong, and corporate profits and margins have remained robust in the first quarter of this year. 'This time is different?' Probably not.

We expect that, unlike Godot in Samuel Beckett's play, a recession in the US will appear by the end of this year.

Germany – Europe's largest economy – did not escape this recession over the winter months after a mild winter and a sharp drop in energy prices fuelled hopes of escaping it.

Economic output fell by 0.3 per cent in the first quarter, the second successive quarterly fall.

The main factor was weak consumption, which was burdened by high inflation rates.

The weakening in demand was most recently reflected in a greater than expected decline in both headline and core inflation.

Uncertainty about future macroeconomic developments is manifesting itself in high volatility in interest rate expectations.

The broad improvement in the latter indicates that the decline is not only due to mechanical base effects.

This is a welcome development for the European Central Bank.

Although the central bank is likely to have walked a large part of its interest rate path, we do not expect it to prematurely declare the inflation battle over.

This is also true for the other major central banks and the US Fed in particular.

Bonds: credit spreads reflect great optimism 

In any case, central banks themselves provide little guidance to market participants due to their data dependency.

As a result, uncertainty about future macroeconomic developments is manifesting itself in high volatility in interest rate expectations and thus in particular at the short end of the yield curve.

Whereas a month ago investors were expecting the first US interest rate cuts this year, the interest rate market is now pricing in further interest rate hikes by the end of the year.

Despite all this, corporate bonds are proving surprisingly robust. Credit spreads have remained stable.

With valuations having risen again overall, a more cautious approach is obvious.

While this is understandable for investment-grade bonds, whose risk premium over government bonds sufficiently compensates for expected defaults in the environment of a recession at the current level, this is not the case for the lower end of the rating spectrum.

Given their high leverage and thus fragile capital structures, the credit risk premium on high-yield bonds gives less leeway to navigate through a downturn, even if it is only mild.

In addition, central banks are unlikely to move hastily into an accommodative regime given the still-high inflation rates, while the recent dispute over the debt ceiling in the US suggests that fiscal policy is also unlikely to be able to dampen a pronounced default cycle.

We therefore expect credit spreads to rise and better entry opportunities over the coming 12 months.

Equities: narrow market leadership 

The dispersion in returns on the equities markets between individual sectors are extremely high, especially in the US.

Eight out of 11 sectors are underperforming the overall market.

Or to make it even more explicit: if you remove the largest seven companies from the S&P 500, the index is unchanged from the beginning of the year.

The recent equity market strength is the most concentrated in 25 years and not an expression of robustness. 

This picture is also reflected by the recent improvement in earnings expectations, which are also mainly found in the technology sector.

The performance at index level thus masks the underlying reality to a certain extent.

With valuations having risen again overall, a more cautious approach is obvious in this context.

Asset allocation – recession ahead? 

The macroeconomic environment has proven to be more robust than expected in recent months.

However, inflation rates that remain well above the central banks' target rates are increasing the pressure on monetary policymakers to continue on their path of interest rate hikes, which is likely to weigh more heavily on economic activity accordingly.

Signs of this can be seen in more and more leading indicators, which are increasingly losing steam after the recovery of recent months.

Companies will find it difficult to maintain earnings growth and defend high margin levels in this environment.

High-yield bonds in particular are likely to come under selling pressure.

We therefore remain underweight in equities, with a preference for defensive regions and sectors.

We remain overweight in bonds, with a preference for high-quality bonds; inflation-linked bonds are also attractive due to the highest real yields since 2009.

At the lower end of the rating spectrum, we remain underweight.

High-yield bonds in particular are likely to come under selling pressure as economic activity weakens, with rising credit spreads weighing on the asset class.

Due to favourable monetary conditions, we like emerging markets bonds, especially but not exclusively in local currency.

Some regions, in particular in Latin America, are gradually gaining more room for interest rate cuts due to favourable inflationary developments in order to support their economies.

We are maintaining our overweight in cash and alternative investments.

The former in order to be able to exploit tactical opportunities in the short term; the latter due to the positive diversification effect at portfolio level.

Phillip Bärtschi is the chief investment officer at J Safra Sarasin Sustainable Asset Management