September 01 2023

R* Under a Cloudy Sky

Ignore the technicalities behind the debate of rate setting for a moment. The mere fact that the debate exists suggests that we might be at a turning point where economic activity is cooling and higher rates are no longer justified.

But, but, the market has not finished to rally, you would say. In fact, it is rallying on the back of potentially decreasing rates in the future. Until economic data really points downward, it is a net positive. Right?

For signs of this pivot, look at the bond market. The long end started to shift, albeit timidly. US 20-year treasuries show signs of bottoming out. It wouldn’t be surprising to see further tightening of the spread between the 2yr and the 10yr going forward.

It means that medium-to-long-duration high-quality bonds are meant to rally. However, I’d be wary about the effect of worsening financial conditions on lower quality companies and typically high yield. High yield credit spreads look tight historically, and relatively to a weakening global economy. The past tightening has been predicated on relatively benign economic conditions, and abundance of financing supply. Looks like both are at risk of taking a plunge, as the refinancing wall approaches in a more restrictive economic environment.

Normalization is finally here, even if the new normal doesn’t look exactly like pre-covid. It might be the case that rates, inflation and economic growth are all trending higher for a while, and this is ok too. Bear in mind that 10-year rates above 4% used to be the norm pre-GFC.

Does it mean that we could gradually wean off QE and an era of abundant and cheap money? This is a debate for another time, but normalization overall should have a recalibrating effect on markets. I’d typically expect a repricing of risk in the more speculative asset classes.

As the rebalancing takes place, I’d be looking to decrease weight on US assets, and pivot into Europe and EM. By asset class, re-weighting out of equities, in favour of mid-duration higher quality bonds is not foolish. In private assets, I’d rather allocate to new vintage funds. Nothing is one-size-fits-all of course, and there are opportunities in dislocated markets. In my opinion, equity valuations in China are meant to revert to the mean, sounder financial Western companies bear attractive risk-return post SVB debacle, and some companies will benefit from a domestic edge in a changing geopolitical environment e.g. chip-makers, EV-related, infrastructure typically energy.

By focusing intently, one can always find stars amidst the clouds.

Stay safe out there !

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360 Advisory LLC is a Boston-based RIA managing investments