THEand central banks developed markets are moving towards rate cuts, but with very different timing. European Central Bankthe Bank of Canada, the Swiss National Bank and the Bank of England have all cut rates in recent months and will likely cut further in 2024. The Federal Reserve has not yet cut, but is expected to start soon, especially given signs of weakness emerging from the labor market. Meanwhile, the Bank of Japan just raised interest rates in late July. They point out Marc Seidner, CIO Non-Traditional Strategies at PIMCO and Pramol Dhawan, PIMCO Portfolio Manager analyzing the ongoing dispersion of markets and monetary policy.
“The Summer of Dispersion”
We anticipated this dispersion in our April 2024 Cyclical Outlook“Divergence in markets, diversification in portfolios”arguing that the increasingly asynchronous paths of economic growth, inflation and central bank policy across countries would create high volatility and attractive investment opportunities in global bond markets.
Lately, the divergence theme has been playing out in real time, extending beyond sovereign debt to include equity markets as well.of credit and actions. Some examples:
- An encouraging inflation report, following a series of disappointing reports, led to a rally in Australian 2-year bonds on July 31. The Bank of Japan raised interest rates by 25 basis points (bps) on the same day, and Japanese 2-year yields rose. The moves produced an immediate 30bp differentiation between Australian and Japanese front-end rates.
- Spread dispersion in the CDX High Yield Index is near record highs. As of August 2, 37% of the broad credit spreads in the widely followed market gauge were derived from the 10 constituent issuers trading with the widest spreads (see chart 1), reflecting elevated default risk and depressed recovery prospects for the lowest-rated bonds. Across much of the rest of the high yield market, spreads have been unusually tight.
- The stock market has seen a huge divergence between high-growth tech companies and small-caps. Big tech stocks have fallen lately on weak earnings and concerns about AI investment returns, while small-caps have surged. This rotation has followed months of strong outperformance and crowded positioning in tech stocks. As of July 10, the Nasdaq 100 had outperformed the Russell 2000 by 21.7% through 2024. Since then, the Russell has outperformed the Nasdaq by 13.6% through August 2, including a record outperformance of 5.8% on July 11.
- Stocks fell and bonds rose in early August after a disappointing July jobs report reignited months-old U.S. recession fears. Not just dispersion, but also illiquidity is at play: For example, Japan’s Nikkei stock index fell 12.4% on August 5, entering negative territory for the year, before recovering nearly all of its losses the following session.
PIMCO’s comment
We expect continued volatility and dispersion globally, as tight monetary policy and elevated levels of sovereign debt threaten economic growth, especially in a year of important elections in countries that account for 60% of global GDP. Fortunately, this type of volatility can create attractive trading opportunities for active managers.
The recent market woes have been a wake-up call for many investors who have enjoyed favorable returns in stocks and cash for much of the year. Back in May, we highlighted the potential benefits of extending duration and locking in attractive bond yields. As we said then, a yield decline of just 80 basis points has the potential to generate price appreciation and cause a portfolio of short- and intermediate-maturity bonds to double the yield on cash. Since then, the 2-year Treasury yield has fallen more than a percentage point.
More economic risks ahead
The central banks “they were good at taming the post-pandemic inflation surge with coordinated interest rate hikes. Inflation in many regions briefly spiked to painful levels, but has continued to decline, thanks in large part to the swift actions of policymakers. Rates have also remained relatively low and have recently been on a downward path, providing a tailwind for bonds.”
Signs of weakening in other developed economies have contrasted for months with the resilience of growth american, but lately even the United States appears vulnerable.
July employment data hit the activation threshold of the Sahm Rule, ua Fed indicator (based on employment data) that has proven to be a reliable indicator of US recession in the past. It is worth noting that historically this rule has kicked in when actual employment levels are declining, which has not happened significantly yet – the recent weakness has more to do with labor supply, as more job seekers enter the market
However, labor market tensions “could justify an acceleration in the pace of rate cuts once the Fed begins to ease. This would be consistent with previous cycles. Since the 1980s, when the Fed has raised rates, only 25% of the hikes have been more than 25 bps. By contrast, when the Fed has cut, it has done so in increments greater than 25 bps about half the time. History also shows that analysts regularly underestimate how aggressively central banks cut rates.”
In this emerging divergence of policies, “we consider the following interesting country bonds such as the UK, Canada and Australia, due to downside risks to economic growth, improving inflation prospects and how interest rates are more directly impacting the economy through home loan structures. We also like trades that are positioning themselves for the potential outcomes of this global dispersion, such asand steeper yield curves in the United States compared to the flatter ones in Japan.”
The recent market swings – the experts conclude – “also remind us of the hedging properties of bonds, which tend to shine in these conditions. The diversification offered by an allocation global bond actively managed can act as a broad-based ballast, generating attractive income potential and capital appreciation, especially in volatile times. Think of an allocation to bond funds as an attractive option to maintain the fresh walletsie comfortable on a hot summer day”.
