Positioning for a “slow” slowdown

The dust is settling after March’s episode of banking stress. Early indications suggest to us the outlook for a continued economic expansion is intact. In fact, the backdrop to begin the second quarter is fairly similar to where we started the year. In our view, in that consensus is too pessimistic in expecting a recession around the corner.

Concerns about the health of the financial sector have not triggered a meaningful, immediate deterioration in economic growth. The robust starting point for nominal activity means that growth has room to slow before we need to worry about an imminent economic contraction.

We remain more optimistic than consensus on the near-term outlook for activity, but acknowledge that the range of outcomes remains wide. The outlook for growth and inflation remains uncertain. Major asset classes reflect this uncertainty, in our view, with stocks, bond yields, and the US dollar stuck within ranges year-to-date.

US stocks are pricing in a soft landing, whereas bond markets are pricing in too much recession risk, in our view. We expect this to be resolved with bond yields moving higher and growth-heavy US stock indexes moving lower from the top of their range.

International equities remain attractive relative to US stocks, as we see the growth impulse moving in favor of China and Europe. We believe this turn in relative growth will also cause the US dollar to weaken over time. A not too hot and not too cold global economy also favors the cheaper areas of credit, specifically emerging market debt and European investment grade (IG). The key risk to our view of economic resilience would be a failure of the US government to raise the debt ceiling this summer.

We believe the economy is in for more of a “slow” slowdown than a sudden stop.

Labor markets in the US and Europe are still tight and continue to support improvements in consumer spending. Composite Purchasing Managers’ Indexes for both the US and Europe point to a moderate, solid expansion in aggregative activity. European industrial production is bouncing back as concerns over the supply and cost of energy this past winter have faded.

Keeping you up-to-date with markets

Importantly, US real estate looks to be stabilizing, with a solid outlook for construction. In past cycles, housing weakness has been sufficient for a broad-based deterioration in labor market conditions. This cycle, we believe we have already weathered the most severe part of this retrenchment. Given the large structural demand from millennials, recovery in US immigration, and tight inventories, either a different catalyst or substantially higher interest rates are likely needed to bring about labor market pain.

Quarterly reports from US financials also suggest that deposit flight has largely abated or begun to reverse since mid-to-late March, in most cases. This corroborates our view that lingering issues in US regional banks are idiosyncratic and isolated. We simply don’t see much evidence that growth is about to fall off a cliff.

Exhibit 3: High yield spreads suggest compelling valuation case in EM USD credit

Source: UBS-AM, JPMorgan, Bloomberg. Data as of April 27, 2023

The key risk to this view is if the US government is unable to raise the debt ceiling by the so-called X-date, which will be reached at some point this summer (at the time of writing, there is not much clarity on exact timing). However, the main risk associated with the debt ceiling is not a sovereign default, which would be the basis of a major financial crisis. We believe the risk of a sovereign default is very low, as we are confident the US Treasury would prioritize principal and interest payments on its debt. Such an outcome, however, would still likely entail cuts in spending elsewhere, which could lead to a sharp hit to economic growth, and likely recession. Ironically, Treasuries would likely rally if the US fails to reach a debt ceiling agreement given the expected material hit to growth.

As much as we see upside risk to yields, the lack of a near-term resolution and potential fiscal fallout from debt ceiling negotiations will cap how high US Treasury yields can climb, in our view. This limits some of the downside risk for corporate bonds on an all-in basis. And from a broader market perspective, fiscal policy that contributes to below-trend growth may be part of the solution to the lingering inflation problem.

2022 was an environment in which major asset classes trended – dollar and yields up, and stocks down. 2023 has been a much choppier environment. This bolsters the relative appeal of credit, as coupons offer some visibility into consistent returns in what has been a directionless market. Corporate bonds may not be the highest-beta option to benefit from economic resilience, but it is an asset class that provides a solid risk-adjusted return in a not too hot and not too cold environment.

In particular, we prefer European investment grade credit and emerging market dollar denominated bonds. European IG is pricing in excessive economic deceleration even as the macro data in the Eurozone picks up steam. The attractive valuation is driven largely by the widening in the financials sector. Bank stress, in our view, was moderate and short-lived, and spreads have more room to retrace to reflect this reality.

The valuation case is also compelling for emerging market dollar-denominated bonds. Spreads are very elevated on a historical basis, a function of widening in the high yield segment of the market, and in particular the weakest parts of the index. The low-rated portion of the EMBI Global Diversified index is trading at extreme levels with a few countries likely to get IMF support. This should provide positive return asymmetry.

Global equities – particularly US large-caps – are quite expensive, and a deceleration in growth may contribute to downward pressure on future earnings-per-share estimates. However, the market-implied path for the Federal Reserve’s policy rate includes much more easing delivered in the second half of 2023 than is consistent with what we believe will be still-strong labor markets and above-target price pressures. As cuts are priced out, this should put upward pressure on US bond yields, which may also cause some de-rating in highly priced US growth stocks. International equities look more attractive to us, as China and Europe show relative economic strength and are cheaper than US markets.

The chart below shows the views of our Asset Allocation team on overall asset class attractiveness as of 28 April 2023. The colored squares on the left provide our overall signal for global equities, rates, and credit. The rest of the ratings pertain to the relative attractiveness of certain regions within the asset classes of equities, rates, credit and currencies. Because the ACA does not include all asset classes, the net overall signal may be somewhat negative or positive.

Source: UBS Asset Management Investment Solutions Macro Asset Allocation Strategy team as of April 28, 2023. Views are provided on the basis of a 3-12 month investment horizon, are not necessarily reflective of actual portfolio positioning and are subject to change.