Equity Strategy - Trading around the last Fed hike: typically low beta bond proxies work; Equities-bonds correlation turning

Speaker: Mislav Matejka, Head of Global Equity Strategy

 

Our view remains that Q1 will have likely marked the high point for equity prices for this year, and we look for recessionary trading in 2H, with low beta preference, and an increasing caution on Cyclicals/Banks/Value exposure. As the initial SVB/CS driven correction was sharp, we argued last week that market appeared oversold short term, with relief bounce likely, but also that one should use the bounces to reduce exposure. We do not see these rebounds persisting, the policy mistake risk keeps building. In a nutshell, we do not expect a fundamental improvement in equities risk-reward until the Fed is advanced with rate cuts. Within this, we believe that the bonds-equities correlation is reversing. Both bonds and equities lost money in 1H of last year, then both made money into year-end ’22 – the correlation was positive. As the recession odds are likely increasing again for 2H of this year, in our view, we think the correlation is likely to go back to a normal, inverse one. This should mean that, in down markets, low beta works, as is typical of risk-off trading, and is opposite to last year, when Value worked. The point of the last Fed hike in the cycle is approaching, and we note that bond yields move strongly lower in the aftermath of last hike. Looking at market internals, there is a clear preference for low beta bond proxies into, and post, the last Fed hike in the cycle. Healthcare and Staples were the consistent outperformers. The question is how does this align with what is still seen as a robust labour market. We see the labour market as a lagging indicator of the cycle, it is likely that there is already weakening beneath the surface – note the construction job openings falling, and the Challenger job cuts moving up. It is notable that the amount of time that passes between the best/lowest unemployment rate in the cycle, and the official start of a recession, is quite short historically. It would not be unusual for the economy to see the best labour market prints in Q1 of the year, only for the 2H to potentially show recessionary behaviour. Will lower yields help equity valuations? Equity dividend yield vs bond yield gaps, vs historical averages, are not overly exciting, at present. US and Eurozone have DY-BY gaps below what is seen on average, while only Japan stands out as a clear positive. Cash at near 5% is a very high hurdle rate to surpass to be long risk assets at this stage.

This podcast was recorded on 26th March 2023.

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