You might remember towards the end of last year we did an Innovation looking at total (government + non-financial corporate) debt across various countries. Japan was at the top, but some of the next countries down seemed surprising. Sweden, Switzerland, France.
I had half forgotten about it myself, but was reminded of it last week when I saw a list of developed market central banks who had cut interest rates soonest. Sweden, Switzerland, the EU. It is unusual for smaller central banks to cut rates ahead of the US. Sweden and Switzerland also have very high debt service ratios, both over 20%. The US is about 15% and the UK a relatively modest 14%.
This morning Christine Lagarde, President of the ECB announced the EU would not be using its Transmission Protection Instrument (TPI) to buy the bonds of countries that make “policy errors”. She is talking about France, whose bond yields have risen dramatically since President Macron announced a snap parliamentary election last week.
Meanwhile in the US, the FOMC kept US interest rates on hold as expected. But within the surrounding commentary, they increased their long-term interest rate assumption to 2.75% from 2.5% where it has been since before the pandemic. In other words they are saying they think long term inflation is higher than they thought all the way through the inflationary shock we just had.
US inflation has stayed sticky at around 3.5%. Real yields have been rising as inflation has fallen and are now high, particularly compared to the recent past. Financial conditions are tight.
In their statement following the meeting in May, the FOMC had noted that “we find that the debt-service capacity of the US public corporate sector as a whole is robust to sustained elevated interest rates”.
However they go on to say that although this is true in aggregate, higher for longer rates will weaken companies with weaker balance sheets, including some large investment grade (IG) firms, who up to now have been shielded from higher rates by their high share of the fixed rate market.
Both IG and high yield bond spreads are currently tight in the US, and have been for some time. You are not being paid much for the additional risk over government bonds. As the Fed notes, corporate balance sheets are relatively strong and defaults have stayed low.
US Corporate bonds have performed relatively well over the last twelve months despite the tighter spreads on offer. But I believe we are starting to see some signs of strain from higher for longer rates and inflation.
I sometimes feel we have almost forgotten about the yield curve inverting – or have grown used to it. The inversion of the yield curve is a sign that financial conditions are too tight, which leads both corporates and households to reduce their borrowing, and this in turn reduces growth.
It is still going to unwind at some point and there are two ways for this to happen. It has been inverted now for over 20 months. In 2008 for example it lasted 27 months. The way in which it unwinds will be important. In their central case the FOMC believe long term interest rates will stay about where they are – about 4.5% in the US, but short-term rates will gradually decline.
Also last week came news that the cost of shipping containers from China to Europe has gone from less than $1,000 per 20ft container to nearly $4,000. This is about where it was when a grounded ship was blocking the Suez Canal in 2021. It seems to have disappeared from the news, but Houthi rebels are still disrupting ships in the Red Sea.
These kinds of inflationary shocks are likely to persist, and there are other ongoing issues, such as energy transition which are likely to be inflationary over the medium term.
If we are in an environment with both persistently higher inflation and more one off inflationary shocks caused by for example increased geopolitical tensions then this will have a big impact on both asset allocation as well as stock selection in multi-asset portfolios.
Meanwhile the extreme valuation differences between small and large cap, value and growth and the US and the rest of the world continue to widen. Equity market momentum as a factor has just hit a relative high. Rate cuts have finally started in developed markets and the second half of 2024 is likely be different than the first.
Robert Fullerton – Senior Research Analyst
FPC24164
All charts and data sourced from FactSet
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