Payden & Rygel: 2024 - The Year of the Dragon

5 maart 2024

The end of each year prompts celebrations and reflections on what lies ahead. While New Year's marks this transition globally, customs and festivities differ greatly between Western and Eastern societies.

Western cultures, following the Gregorian calendar, observe a brief one-day celebration on January 1st. In contrast, Eastern cultures, often guided by the Lunar calendar starting between late January and early February, engage in festivities lasting several weeks.

Among these, the Chinese New Year stands out, employing the unique Chinese zodiac to designate each year with distinct attributes. Rooted in belief, the Chinese zodiac shapes societal roles and structures, offering a markedly different perspective on the new year compared to Western traditions.

Forecasting the year ahead varies depending on cultural perspectives. In Western societies, where global financial markets typically hold sway, outlooks drafted in December for a January 1st new year often lose relevance by the time Chinese New Year celebrations commence. Conversely, in Eastern societies like China, optimism abounds at the start of the new year, particularly during a special year like this one: the Year of the Dragon.

The Year of the Dragon holds particular significance in Chinese culture. As the only mythical creature in the Chinese zodiac, the dragon symbolizes light, authority, and prosperity, promising good fortune.

However, it turns out that like financial market outlooks, the global perception of dragons is quite disparate. While revered in China, Western folklore often associate dragons with darkness and destruction. The contrast between these interpretations underscores the uncertainty surrounding the year ahead and its potential implications for financial markets, mirroring the disparate views on dragons.

Western Dragon

In financial market terms, the Western dragon symbolizes a recession, casting darkness over the labor market and corporate profits, and wreaking havoc on valuations in risk assets such as equities and high-yield corporate bonds.

Since the beginning of 2022, market consensus has repeatedly anticipated the emergence of the Western dragon from its hiding place. Poor leading economic indicators, contraction in bank lending, and elevated interest rates: something must surely break. Recession is inevitable. Why hasn't the Western dragon awoken yet? Let's examine these factors individually.

Poor Leading Economic Indicators

The Leading Economic Indicator (LEI) index is comprised of various inputs that typically precede changes in overall economic activity. These inputs include economic measures like employment, business activity, manufacturing as well as financial market indicators like equity prices and the shape of the yield curve. Since 1990, the LEI has turned negative on average 12 months prior to a recession.

However, the range has varied, with the lead time as short as 6 months before the 2020 recession and as long as 19 months before the 2007 recession. Despite the LEI being in negative territory for the past 20 months, a recession has not materialized.

Why? The composition of the LEI index changes over time, with modifications to both inputs and weights based on past experiences involving the economic landscape. This makes sense as models should be adjusted to conform to changing environments, but accurately adjusting models can be challenging, and the fluid nature of the economy can make comparing current readings to historic analogues difficult.

For example, the aggregated economic output (GDP) in the US today is comprised of 80% services and only 9% manufacturing, a material change from nearly 30% of output deriving from manufacturing 40 years ago. In contrast, the LEI index currently includes ten measures in total, with four of those measures related to manufacturing. This discrepancy skews the LEI towards manufacturing, diverging from the actual composition of economic output.

Elevated Real Rates

Global interest rates have been rising for nearly four years, most notably in developed markets where both nominal and real interest rates have increased at a pace unseen since the 1970s.

For example, 10-year US Treasury yields surged nearly 400 basis points (bps) from 0.58% in July 2020 to 4.31% as of February 13, 2024, while 10-year real yields have climbed from -1.03% to 2.02% during the same period. This marks an extraordinary move, especially considering the market's conditioning to lower interest rates over the last several decades.

The natural response to such a rate hike is concern that it may be too restrictive and unsustainable, leading to an eventual breakdown. Undoubtedly, a few things have broken along the way: the cryptocurrency market in 2022, the regional banking episode in 2023, and the broader office sector within commercial real estate. This raises the question: Are interest rates too restrictive? The answer likely depends on your timeframe.

Using 10-year real rates in the US as an example, from 1990 to 2002, they averaged 3.8%. From 2002 to 2023, the average dropped to 0.9%. Since the beginning of 2023, they have averaged 1.7%, with current rates at 2.02%. Are these rates restrictive? When put in the context of the 2000s and 2010s, the answer is yes. However, in the context of longer-term history, the answer is no.

The broad US economy has displayed remarkable resilience to higher interest rates, both in nominal and real terms. This resilience can be attributed to several factors.

First, households have been deleveraging for more than a decade since the Global Financial Crisis (GFC) in 2008, up until the COVID-19 experience in 2020.

Second, the exceptionally low interest rate environment from 2020 to 2021 sparked a tidal wave of refinancing activity at both the corporate and household levels.

Third, financing in the US housing market is heavily skewed toward a 30-year term. The bottom line is that the US economy is driven by consumption and corporate profits, with both consumers (households) and corporations being less sensitive to interest rates today compared to previous cycles.

Eastern Dragon

While the Western dragon has made several attempts to emerge from hiding, the Eastern dragon has been occupying the skies for multiple quarters, largely shining light and prosperity on financial markets. Global growth has remained robust, particularly in the US, as the Eastern dragon has been fueled by a combination of fiscal stimulus, abating inflation, and a more balanced posture from global central banks.

However, as the benefits from these factors diminish, the Eastern dragon must seek new sources of strength to continue its ascent in 2024. If it looks closely enough, the dragon will realize that these sources can be both economic and financial markets in nature.

On the economic front, the dragon should seek strength in the labor market, especially one underpinned by stable wage growth. Simultaneously, on the financial market front, nothing would enhance its flight through the blues skies more than favorable financial conditions. Let's unpack why this combination will position the Eastern dragon favorably to bestow good fortune, even if the Western dragon awakens.

Strong Labor

The global labor market has enjoyed robust health for several years, fueled by the reopening of economies and the corresponding demand surge post-Covid. However, signs of labor divergence are emerging, particularly in developed markets.

Countries like Canada are exhibiting signs of deterioration, whereas the US is broadly maintaining strong footing. For instance, in Canada, job vacancies per unemployed persons are approaching pre-Covid levels, while the unemployment rate has risen by 0.8% and is nearing pre-Covid levels.

In contrast, although the US unemployment rate has slightly increased from 3.5% to 3.7%, job vacancies per unemployed persons remain elevated compared to pre-Covid levels. Perhaps more importantly, weekly unemployment filings (initial jobless claims) in the US remain subdued.

Analyzing the US weekly jobless claims series dating back to 1970, there have been only 10 instances of weekly jobless claims below +200k. The weekly average from December 1st, 2023, to February 2nd, 2024, stands at +210k. One reading during this stretch came in at +187k, the second lowest print in 50 years.

However, the Eastern dragon should not solely focus on elevated job openings and low unemployment filings when assessing the labor market. It should also consider wages. Nominal wage growth remains elevated in most developed countries, and more importantly, real wages are rising as inflation has declined. The result is more money in the pockets of consumers, providing a tailwind for consumption.

This trend is particularly noteworthy in the US, where fiscal stimulus has been substantial and household leverage lower compared to other developed countries. With all that said, the Eastern dragon should remain vigilant for storm clouds on the horizon, even in the US. Preliminary signs of labor market softening include a downward trend in overtime hours and a shorter aggregate workweek over the last few years.

Easy Financial Conditions

Financial conditions are typically gauged by real-time asset prices or financial market-based measures. For example, the Goldman Sachs (GS) Financial Conditions Index combines short and long-term interest rates, the trade-weighted US dollar, credit spreads or risk premiums, and equity valuations into a weighted average.

This index serves as a real-time indicator for financial market trajectory, asset price volatility, and corresponding economic impulse. However, financial conditions are also influenced by less real-time, and slower-moving factors such as fiscal and monetary policy, which shape broad economic activity, borrowing and spending behavior, and financial market trajectory.

Given this backdrop, how should the Eastern dragon interpret current financial conditions?

First, recent readings of real-time measures like the GS Financial Conditions Index remain below 30-year averages, indicating an environment favoring easing over restriction. This is noteworthy despite significant monetary policy tightening since 2021.

Second, the two-month period of November and December 2023 witnessed the largest two-month easing in the GS Financial Conditions Index going back several decades.

Third, global monetary policy, including that of the US Federal Reserve, has shifted from a hawkish and hiking stance to one of leniency and easing. This shift in policy should help mitigate disruptions in financial conditions associated with growth concerns or turbulence in the financial system’s workings. Finally, while varied in magnitude, global fiscal policies continue to be accommodative, especially in developed countries where austerity measures are deemed undesirable.

Unconstrained Bond Strategy Implications

The synergy of a robust labor market and a collective easing of financial conditions is poised to keep the Eastern dragon airborne for the first part of 2024. With that said, we suspect a strong interconnection between the Eastern and Western dragon. Specifically, the Eastern dragon’s growing strength heightens the chances of the Western dragon stirring from its slumber.

Why? The answer lies in sequencing. A stronger for longer market coupled with favorable financial conditions and rising asset prices increases the probability of economic growth, and by extension, inflationary impulse. This may curb expectations of continued loose monetary policy, leading to higher interest rates, diminished asset values, and tighter financial conditions. The resulting negative wealth effect could dampen consumption, weaken the labor market, and ultimately trigger a recession. The Western dragon has awoken.

Indeed, this sequencing unfolded in Q3 and early Q4 of 2023 and has shown signs of resurgence in 2024, evident in economic data trends compared to forecasts and market pricing. Given this context, the Unconstrained bond team is paying close attention to correlations, particularly between risky assets like equities and high-yield corporate bonds and less risky assets like US Treasuries.

In the post-Covid regime, this relationship has largely been positive due to heightened inflation, which differs greatly from the negative correlations observed in the 20-year period leading up to Covid. This relationship is crucial for portfolios that include both interest rate and credit risk given positive correlations mitigate the diversification benefit typically associated with interest rate duration.

The Unconstrained bond team also believes the current environment differs from the last 20 years given elevated yields in liquid public markets and an inverted yield curve. Credit spreads in most sectors are deemed fair at best and expensive at worst. Hence, investors may capitalize on market conditions by shortening maturity profiles, upgrading credit quality, transitioning from less liquid private markets to more liquid public markets, all while preserving running yield and continuing participation if markets remain sanguine.

Looking ahead, the active management and flexibility inherent in an unconstrained bond strategy are important ingredients as global macroeconomic trajectories diverge, volatility increases, and opportunities arise. Although diversification is another key component, excessive diversification can be detrimental, so the team is focused on targeted exposure and themes across corporate credit, emerging markets, and securitized products.

Crucially, the combination of elevated yields and the shorter maturity nature of the Payden Unconstrained bond strategy reinforce the likelihood that outcomes are more predictable and balanced in the event the Eastern dragon is joined or supplanted by the Western dragon in the skies throughout 2024.