August has been very volatile so far for global equity and fixed income markets. In the first few days of the month, the S&P 500 fell more than 6%, and Japan's Nikkei 225 recorded a dramatic 20% drop. Both indices have now recovered about half of their losses.
The 10-year Treasury yield fell more than 20 basis points, but is now back to where it was earlier this month. Volatility indicators for equity and interest rate markets, the VIX and MOVE indexes, have also risen sharply. Although they have declined from their recent peaks, they remain elevated. We begin this week by focusing on the debates that have caused such sharp market moves and how we expect them to unfold in the near term.
At the heart of the market volatility, in our view, is a shift in the market narrative about US economic growth. Although it is worth noting that our economists’ views on the outlook have not changed. Despite downside surprises in the last few weeks, such as the latest ISM manufacturing PMI, the overall weakness in the July US jobs report was the trigger for the latest volatility, bringing the risk of a hard landing into focus and, with it, triggering a change in expectations about the path of the Fed’s monetary policy. This is in stark contrast to the particularly bullish thesis that had been inflated in market prices, which had led to stretched market valuations. Market pricing for Fed rate cuts has again changed dramatically this year, from less than two 25 basis point cuts a month ago to more than five now, with more than two-thirds of the probability of a 50 basis point cut at the September meeting.
Our economists' baseline forecast for a soft landing remains unchanged, and they expect continued declines in inflation to drive a rate-cutting cycle, with the Fed set to begin three 25bp rate cuts this year at the September FOMC meeting. However, the market is likely to continue to challenge the soft landing view (i.e., continued deceleration of the U.S. economy without a crash) until some "good data" emerges. As Morgan Stanley's chief global economist Seth Carpenter points out, it would take another month of weak labor market data (nonfarm payrolls falling to close to 100,000) or continued weakness in PMI data (manufacturing and services) and a clear rise in unemployment claims to change the Fed's stance.
The soft landing argument was reinforced by last week's below-consensus initial jobless claims and last month's claims data, which showed no signs of a sustained broad slowdown in the labor market. The Bank of Japan's hawkish rate hike last week also caused sharp volatility in global markets. Although Morgan Stanley economists expected it, the rate hike was hardly a consensus.
The real surprise was the notable shift from Kazuo Ueda's decidedly hawkish stance at the press conference, hinting at the possibility of an early back-to-back rate hike. Coupled with growth concerns brought about by U.S. employment data in July, it has raised the possibility of further interest rate cuts by the Federal Reserve. The hawkish stance of the Bank of Japan means that the policy differences between the Federal Reserve and the Bank of Japan have become more obvious. Lift” had a knock-on effect. While the Bank of Japan's "damage control communications" calmed market jitters following Ueda's hawkish comments, our Japan macro and equity strategists Koichi Sugisaki and Sho Nakazawa noted that only about 60% of yen arbitrage The transaction has been cancelled. As they emphasize, the margin of error in their estimates is large.
In credit markets, we believe recent weakness in spread products is justified, especially given the tight starting levels. In the US corporate credit market, recession risk is at least priced into high yield single B-rated bonds, which are highly valued and over-positioned. We recommend investors hold a hedge against hard landing risk rather than reducing cash portfolios.
The put spreads on high yield TRS and high yield CDX are reasonable in our view. Investment grade is likely to outperform high yield in terms of emerging market sovereign credits, which leads us to close our preference on high yield over investment grade. We recommend a portfolio of emerging market single name CDS as an attractive hedge.
What happens next? Although risk markets have reversed some losses and US Treasuries have given up some gains, we expect markets to remain nervous until data confirms or denies the soft/hard landing scenario for the US economy.
Every piece of data that comes out, especially related to the labor market, will be watched closely. We will also be watching closely the healthy functioning of funding markets and capital market access for companies to get credit.
Funding markets have remained intact so far, with some investment grade bond trading that was pulled from the market early last week returning and being welcomed – with investment grade bond supply (over $30 billion) recording its best year-to-date performance.
Vishwanath Tirupattur, Head of Global Quantitative Research at Morgan Stanley
Article forwarded from: Jinshi Data