The fixed income market’s concern over near-term recession risks is almost surely exaggerated, but it is clear that the market environment is very different than it was a year ago.
Financial conditions have tightened, US fiscal policy stimulus should begin to fade, and political risks are likely to remain elevated in both the US and Europe.
All these factors can weigh on household and business confidence, posing risks to aggregate demand.
US margins are being squeezed
Corporate profit growth is slowing in many major economies. In the US, this is partly due to margin compression as fiscal stimulus pushed the economy far above its potential growth rate, leading to higher labour and input costs across numerous sectors.
If this margin compression worsens, hiring and investment could weaken, causing growth to slow below its trend rate. Even if this bleaker scenario does not play out, declining margins could pose challenges not only to US equities, but also investment grade and high yield credit.
From a relative value perspective, asset allocation alternatives that once were economically unappealing are beginning to look more interesting.
With significant flattening of developed market government bond yield curves, traditional havens like certificates of deposit now yield 2.25% for little to no risk; and the average yield on commercial paper is 2.7%. For anyone willing to extend slightly further out on the fixed income maturity curve, even two-year investment-grade credit could bring the all-in yield to 3.5%.
These alternatives have a clear impact on risk-taking when economic growth is expected to weaken and violent bouts of volatility are common. This suggests there is little benefit to taking a long spread duration position and that the best fixed income exposures are in the front end of the risk space.