The resilience in current macro conditions supported by the positive catalyst of China re-opening has been contributed to a material shift in consensus beliefs on short term interest rate expectations. In the United States, the December 2023 euro dollar implied yield has increased from 4.56% at the start of February to 5.51% today. While resilient macro conditions might reduce the near-term risk on profits, it also increases the odds that the Fed eventually hikes rates to a genuinely restrictive level. That might be why the yield curve is so deeply negative. From our perch, forward looking macro conditions still favour strong balance sheets over weak.
As we have also noted recently, monetary policy works with long and variable lags (around 12-18 months). It will probably take some time for the policy tightening to impact growth and profits. The change in broad financial conditions over the past year has already coincided with a meaningful deceleration (and now a small contraction) in year over year EPS growth. Moreover, near term resilience will likely contribute to a higher peak in policy rates and potentially to another reflexive phase of US dollar strength. Or stated differently further renewed tightening in broad financial conditions.
The positive catalyst of China re-opening received a boost from the February purchasing manager surveys that were much stronger than expected. Our sense is that this development was evident at the end of last year and the time to re-allocate to assets levered to China was in October last year when it was deeply uncomfortable.
As regular readers and clients know, we have often noted the credit impulse or the rate of change in credit growth as a useful leading indicator of liquidity, growth, and asset prices in China (chart 1). The credit impulse made its trough in October 2022 in the phase of “peak fear” and has recovered over the past few months. Although, in contrast to the PMI surveys today, the acceleration in the credit impulse has been modest relative to recent mini cycles. To be fair, January and February data are always distorted by the Lunar calendar. The credit data below is also only updated to the end of January. Today’s data should not be a surprise given the extremely weak starting point. We would expect China to re-accelerate further. However, the episode is much better priced and appreciated than it was in October last year.
Switching back to the key observation that resilient macro conditions have contributed to a further non-trivial rise in US short term interest rate expectations. The big picture implication is that it increases the risk for companies with the weakest balance sheets via an increase in debt servicing and a potential slowdown in cash flows used to service debt. Historically, this point in the cycle favours large relative to small companies and strong balance sheets over weak (chart 2). Not surprisingly, the credit risk premium also tends to rise, especially if the episode leads to a “hard landing” or profit recession. A higher policy rate eventually leads to restrictive conditions, tighter liquidity, higher volatility, and wider risk premia.
To repeat our recent observation, nothing is inevitable, especially in economics and financial markets. However, our big picture point is that the excess return on risk assets (equities and credit) is modest relative to safe assets (chart 3). Stated differently, we can see smoke on the investment horizon, but the premium cost of fire insurance is still inexpensive relative to history. At the very least, investors should continue to avoid profitless companies with highly levered balance sheets. Put another way, long the strong, short the weak.