Direct From Dowding: July 2024

Hello, and welcome to this month's webinar where I plan to speak for about the next 20 min or so, giving an update in terms of some of our thoughts and views around global macro markets as we see them, as we look forward over the course of the summer into the second half of 2024.

As always, plenty to speak about in in the world of macro, and I think that obviously we can begin by sort of reviewing sort of the situation in US rates, markets over the course of the last few weeks. I think one of the things we've been speaking to has been a bit of a sense that we're starting to see a bit of a slowing in the pace of economic data.

Early in the year we had thought that interest rate cuts remained very far distant, because we were confident that there was still a lot of momentum in the economy. But we've started to see some evidence of weakness in business sentiment in retail sales. We're seeing some softening of labour market indicators as well.

And so holistically, we are seeing something of a moderation in activity that we have been looking for a little time, and which we think is likely to continue over the course of the months ahead, partly as past policy steps have some traction.

And at the same time we're seeing inflation has been trending down over the course of the last quarter. Last week's print saw inflation reach 3%. And so, in view of that, I guess the Fed will be relatively content in terms of that trajectory. And although nothing's going to happen which we think is going to be material this month's FOMC meeting. That is the July meeting. We do think it's setting up for a more interesting sort of meeting in September, which, as we previously flagged, we think will probably be the 1st one where we see a Fed rate cut.

Now I would note that before we get to the September FOMC, there will be two further CPI prints now in Q3. Because of the seasonals and the base effects on the data. We think that you're unlikely to see CPI drop any further between now. And when that September FOMC meeting comes around, so inflation will still be sitting around 3%, which is still a bit uncomfortably high for the Fed.

But then, of course, they need to be forward looking in their monthly policy decisions, and if they're content that that downtrend in the inflation trajectory remains intact. If the economy looks to continue to be slowing somewhat, then there's a good chance we think that they will move at that juncture, noting that, if they want to sort of move on rates ahead of the election, September is probably likely to be the last window for them to do so.

So that's obviously interesting. But I would note that in in terms of market pricing in terms of rates contracts. it's almost 100% fully priced now that we get a September move. So on the back of a rally that we've seen at the front end of the curve over the course of the last couple of weeks. We do feel that move is now largely priced, and where we had been articulating, maybe a more constructive view on the front end, up until relatively recently, we now think that we've moved to a point where that's fairly valued could start to become overvalued in particular, because we do think that looking further ahead, the US rates market probably is pricing in too many rate cuts in the ensuing 12 months after the September meeting.

As you go through 2025, you'll see the plot of the Fed fund futures, and the OIS curve is quite some way below the Fed's dots, and so, not for the 1st time, we see the market effectively front running the Fed when it comes to the amount of monetary policy that it expects to be delivered. And I'd note here that from our perspective, although we're seeing some slowing of growth, we don't see anything at the moment that is getting us concerned to make us think that we're going to see a recession in the US economy.

So from that point of view, we don't think that you're going to need a lot of rate cuts. Secondly, I'd note that in terms of inflation we've tended to be a camp thinking that inflation can continue to sit close to 3%. This is largely down to the fact that we think that a peaking of globalisation, a green inflation, premium changes in demographics and a tighter labour market all mean that inflation is likely to sit closer to 3%, we think on a sustainable basis, going forwards compared to the one to 2% levels of inflation that we saw during the 2010s.

And so from that point of view, again, if you think that inflation probably sits there, it probably argues for a higher terminal rate in terms of US Fed funds and we don't think the interest rates are going to decline ever so much in a coming easing cycle. In many respects we see more echoes of a rate cycle that we saw in the 1990s, when there are two occasions where the Fed cut interest rates, but they only came down rates, that is, by 50 or 75 basis points before rates started going back in the other direction. And so all of this leads us to a conclusion to want to probably look, to fade the rally that we're starting to see in yields at this juncture at the front end.

At the same time we remain quite concerned around the backdrop for longer dated yields, and this leads, of course, to the narrative around fiscal policy. Now you have to bear in mind that the Fed is working with a baseline where it's actually expecting a fiscal contraction next year. It has to work on baseline estimates, and that will be that the past temporary tax cuts don't end up getting extended.

Now, the fact that we are thinking that those tax cuts almost certainly will be rolled, that there will be further fiscal easing, I think in part, is also another reason why the Fed may end up thinking its trajectory on rates and delivering fewer rate cuts to the market. But it's also a narrative that obviously is meaning more concerns around debt, sustainability, more concerns around the level of bond supply, which is something that can potentially weigh on markets as we roll forwards.

We've seen this manifest in the yield curve steeping over the course of the last couple of weeks, and of course this links back into the political agenda as well. Ever since we had the debate, which was disastrous for Biden. It's looked very much likely that Trump would be winning, that we might see the Republican clean sweep. If we do see that outcome, that's the most fiscally stimulative outcome that the election is likely to deliver, and on the on the wake of the scenes this weekend with the shooting which was really upsetting to see, and I mean thankfully, it wasn't worse than it was right, but on the on the back of that we only see those dramatic scenes further enhancing the likelihood that we see Trump elected once again for another term as US President.

Some people have been saying, why is there not a bigger market reaction in markets to those scenes today? Well, the truth is that markets had largely discounted a lot of this already. It already looked like Trump was the likely winner.

But in as much as we are going in this direction, the narrative that we end up with steeper yield curves, maybe more pressure on longer dated yields is still something that we think can continue to persist. And even with 2s30s today, reaching a point where that particular slope has disinverted, it's actually gone back to exactly flat today. We think that that can end up inverting to a hundred basis points over the course. steepening to 100 basis points over the course of the coming quarters.

So, generally speaking, on US fixed income we're not that bullish on the outlook on bonds. We're more looking for opportunities on the short side at this time. But in terms of our portfolios and strategies today, the one theme that we're really continuing to run with is this theme of the steepener.

Otherwise moving across the Atlantic to developments in Europe. I'd note that from a European perspective, we think that the ECB meeting this month is also going to be a non-event. We look again to the September meeting, where we think a rate cut is quite likely in terms of ECB. At that juncture thereafter. I think that further ECB moves are going to be very data dependent. And the question is going to be, how sticky is things like wage inflation also, how expansionary is fiscal policy in you going to get.

One of the things that you also need to think about in European policy circles is, if we end up with Trump in the White House. This means that Europe has got a real issue when it comes to defence spend. If they're going to hold back the tide in Ukraine, Europe needs to really commit to a material increase in in defence spending. And this is something that's a very sort of hot topic, a discussion with European policy makers when we visit with European capitals of late.

But that narrative on military spend also on green transition spend as well. All of these are areas where we see net stimulus in the context of both the EU budget and also individual national budgets, and that fiscal easing obviously offsets the need for more monetary easing.

And so from that point of view, we think, yes, we can see a rate cut in September, but as we look forward beyond that it becomes a little bit more questionable.

And I would note that the European economy is doing a bit better than it was certainly this time last year. So, although growth is pretty muted, there isn't an urgency to cut rates, as there would be if we were really staring at a much more recessionary sort of backdrop.

So from that point of view we think that Bond yields again, if anything, could be a little bit sort of rich at this moment in time given that, they trade a long way below where current cash rates are today. Certainly we're not banging the table to go long duration at this juncture. But here and now we're not really running sort of a lot of directional risk when it comes to European rates.

The other thing that has been interesting in Europe, though, has obviously been European, spreads in terms of the respective sovereigns. Plenty of volatility over the course of the past month on the back of the surprise French election. Now, of course, the outcome that we've seen here is one that's led to a degree of stalemate and you can expect the stalemate to persist over the course of the summer. Nothing gets done in in a lot of Europe, we know, in the month of August, and particularly not in France, and particularly not when the Olympics is on. So don't look for rapid resolution in terms of where we're going in terms of the French politics just yet.

But there will be a focus on what the outcome will be within government as we go into the full need to get a budget done at that particular point, and so we wouldn't be surprised to see a bit more volatility coming back in spreads there.

So in the here and now I think, generally speaking, we think that we could be positioning for a bit of a quiet moment in markets as we move into summer. A bit of a summer of carry, perhaps, but we need to be mindful of the fact that volatility can return, we think, as we, as we come back to our desks after that particular break.

And so we are looking at sort of French assets which have recovered from their wides when the election campaign was taking place. But we're looking at those with a view to maybe adding to shorts once more, if we continue to see sort of stronger performance.

Turning to the UK, the UK is now a haven of political stability, relatively speaking. which is all well and good, but the question is how long will the honeymoon last for? I think the main issue that labour confronting is they've got sort of certain ambitions and agenda they'd like to fulfil in the UK. There's a lot much more concern about how much fiscal space do we have? We've seen the disaster under Liz Truss, where labour will be wary of repeating too many mistakes.

And so, although we think there will be some fiscal ease. Again, there's a bit of a limit to how much can actually be delivered in this particular country. We do think the Bank of England is likely to cut interest rates in August. Inflation is a cyclically low point, and this is a window where they can cut before inflation then starts moving back up as we go through the autumn into the winter. Inflation will be trending higher, so it may be one, and done for the time being in terms of the BoE, but for that reason we think that the bank is inclined to move in the course of the coming month.

But again, no real trade on that in the here and now, where we continue to have more conviction, and actually one of the markets which will be more interesting we think over the next couple of weeks is Japan.

Those listening to our comments in the past will know that we've had a long-standing view looking for Japanese rates to move higher. We've thought that Japanese inflation is likely to continue to overshoot bank of Japan expectations. And that requires policy normalisation.

So that's the direction of travel in in Japan. And with that being the case, the monetary policy meeting that happens on the last day of the month of July will be one that we're looking at quite closely. We've already had an announcement at the last monetary policy meeting that the BoJ would be cutting its bond purchases down from 6 trillion, we think, probably to 4 trillion a month, maybe as little as 3 and a half, but we think around 4 is the likely number that markets will probably settle on.

But in addition to reducing that balance, sheet expansion, the other thing that's coming into view now is a potential normalisation in interest rates. We think that, given the weakness of the yen and the pressure on the yen and the real desire within the country to stymie that sort of currency weakness.

We think it's becoming increasingly clear to policymakers in Japan that either they can control the currency or they can control rates. They can't do both simultaneously. Delivering intervention without changing policy only holds back the tide for a limited period of time before the trend continues to move on them.

And so from that point of view, we think that they can't really rely on the US, cutting rates a lot to narrow the rate differential between the 2 markets. They need to be doing more themselves. So we think that there could be a rate hike to 25 basis points in Japan at the end of the month which I think would be interesting. It would also herald yields moving higher.

We think we've had a lot of conviction that ten-year JGBs that have sat around 1% can go somewhere between 125 and 150. But my message to the Bank of Japan has been you can afford to let the market go a bit here, partly because we do think that buyers will actually come back into JGBs once the BoJ is allowing the market to actually find more of a clearing price.

In particular, we think that a lot of big domestic buyers who have long been buyers of overseas fixed income will actually be tempted back into domestic fixed income. Once it feels as if that normalisation has really been allowed to occur from that point of view. If you think about the Japanese yield curve, it is steep cash to thirties now is more than plus 200 basis points.

Contrast that to other global yield curves. And you can see how there is actually carry and roll to be had in Japan. And if you're a financial institution, like a Norinchukin, or others that have run into troubles by investing in overseas rates and being hurt by inverted yield curves and negative carry and roll, again, we think domestic fixed income may end up becoming more interesting, but this can only occur after rates are allowed to correct higher.

In the 1st place, so Japan is going to be interesting to look at could be interesting from an FX point of view as well. If we do see this sort of narrative, that policy is really shifting in Japan, then we know that the yen is a very undervalued currency. It is very cheap and it's actually potentially a currency we want to be long of.

Otherwise. In FX our views have been somewhat towards a weaker dollar. It was quite notable that, with all of the developments going on in France, the dollar was struggling to rally on good news. It was struggling to make new highs then and actually with a data weakening, since the dollar has actually been on something of a retreat.

Now this has been occurring, even though we've actually been pricing high the probability of Donald Trump back in the White House. And if you do see Trump re-elected as we're expecting, then this is an outcome where, if you follow through on a tariff regime, this should be sort of a dollar positive, it should actually mean a stronger dollar is seen on the back of that.

So the fact that the dollar is struggling to rally, struggling to perform, even though you have the idea of trump being priced back in the White House, even though you've had bad news elsewhere, shows that actually, the dollar is generally struggling a bit because it's a very overvalued currency in the here and now.

For the moment, where we think there's more value where we think it is cheap, is EM local rates. EM local currencies, rates and currencies in Mexico, in Brazil, in South Africa, where real yields are very high, where we see double digit nominal yields, and where we think that currencies, having gone through a period of some weakness over the course of the past month, are now doing better. And if we have a bit of a summer of carry environment, we think that local as an asset class, generally speaking, can actually be trading relatively well over the course of the next several weeks.

Otherwise when it comes to credit, credit is pretty boring, which is a pretty happy place to be. It's okay. If credit's boring, it's paying you back. Default rates remain low, recession risk remains low, even if growth is slowing down. Recession risk isn't really there so much and obviously with volatility in indicators like the VIX actually subsiding as well. All of this is conducive to credit market performance.

The other thing that is really worth highlighting, though, is that if you look at the movement of corporate bonds and swap rates. Because if you look at government bonds like US treasuries, it always used to be the case that swap rates would be higher than Treasury rates. Now, today, the swap rate is 40 basis points below the 10 year Treasury rate in the 10 year part of the curve. This really speaks to the degradation of the credit worthiness of US. Government collateral relative to swaps as more of a risk-free asset today. But that's been an interesting shift to behold.

If anything that I mean at the long end of the curve where the swap spread is now minus 70, that may have gone too far. But, generally speaking, it's kind of interesting to see that it's government bonds that have been cheapening relative to everything else.

So part of the narrowing of spread between corporate bonds and government bonds has kind of been the underlying cheapening of government debt, and so, although spreads in corporate bonds look quite compressed now relative to government bonds in somewhere like the US.

If you actually look at corporate bonds relative to underlying swaps, the spread remains relatively attractive, and in an environment of negative net supply, we still think credit can perform where we continue to be more concerned in credit is in some of the areas where you're exposed to leverage, we think a world that is generally a world which is higher for longer is toxic for leverage. Hence we've been structurally quite negative on asset classes like private equity, private debt, where you're relying on entities with a lot more balance sheet leverage within them in order to deliver performance.

So there are areas like that that we don't like in credit. There are areas like euro financials that we still very much do liking credit. So it's a bit of an RV game. But with all of that, my mind is actually now switching to the clock. I can see in front of me, and I'm going to lift up my phone now to see if we've got any questions. As mentioned earlier. We have the Q & A function, and I can see a couple which have come through as I've been speaking.

So the 1st of these was, what direction does fiscal policy taking Europe following the French election. Well, the narrative on this one is that both the parties of the hard left and the hard right both want to spend more. They're both looking to deliver looser fiscal policy. It's only the centrists who are trying to toe the line now, in the short term, if you end up with a paralysis in government. You'll most end up with a technocratic outcome, with nothing getting done then with France now, being under the excessive deficit procedures, there will be a pro forma drafting of a budget which actually has a degree of fiscal restraint within it.

But I think that this is pragmatically unlikely to end up getting passed. What you're likely to see in French politics is some sort of a minority government put together. But in order to get support for a budget there will be probably fiscal easing which is actually delivered in terms of the budgetary stance. People will need to see something in order to sign off and get their support.

But I think the bigger worry here in terms of fiscal policy in France is what's happening longer. Term not short term, as I said in the here and now, things can be contained in France. But what is really key is gonna be what happens in the Presidential elections in 2027. And if you go to towards a a choice between hard right and hard left at that particular vote, then I think that's potentially something that's going to be really concerning for voters, and also concerning to EU policy makers, because, although what is bad for France is bad for France. Anything that's bad for France is also bad for the rest of the EU.

I have a next question, which is, what are our views on the Swiss bank, while the Swiss bank we have tended to think that the Swiss i.e., is likely to weaken. We think the SMB are committed to seeing a somewhat weaker Swiss bank. We've seen that in terms of some of their policy steps over the course of the summer.

At the moment we don't have an active Swissy position within the strategies that we're running. But if you had to ask us for a view, it would be for Euros to go back up to parity or nudge a bit above parity.

And then Ritchie Hobbs has asked for. Given that the call for 2s30s to steepen significantly. Do you believe 2s10s will disinvert before year end? And how much stock do you give this as a recession signal?

Well, firstly, on the yield curve, it is not a recession signal. Sorry I'm going to call it as is, that's ****. It's simply not a recession signal. The reason that the yield curve went inverted was largely down to the central banks, having a lot of credibility bringing inflation back down again and that effectively act as an anchor for the long end of the curve, whereas the front end of the curve was pulled up by monetary tightening. That's the thing that brought about curve inversion.

What was weird though, is that we've had curves that have been inverted for a long period of time. Typically speaking, you only see curves inverted for a short moment before the rate cycle commences and rates come down, and then curves re steepen again. And so in the same way, I thought that negative interest rates in a way, it was almost financial perversion. I mean, we've got inversion, perversion, right? It shouldn't be happening. It's not a normal state of affairs.

So we do think that curves should steepen up, and by the end of the year I think that if we have seen one rate cut from the Fed, maybe even two. If we have seen more concerns around the fiscal, because we're going to end up with tax cuts being rolled. If we end up with more supply going to the long end, we think the whole of the curve can steepen more. So by then I think the sort of 2s30 s, north of 50 basis points seems reasonable and 2s10s we also think can end up disinverting at that moment.

The next question from James Lynn. Please elaborate why your concerns with bonds, and also concerns around private equity and private credit.

So here I think the thing that I'd say is that if I look at private debt as an asset class, the entities that actually underlying those private debt funds tend to be entities that run a lot of balance sheet leverage. So typically companies running 6 to 7 turns of leverage which compares to 3 to 4 turns of leverage in an asset class like high yield. So here where you've got more leverage. I think you have borrowers who are more exposed to the idea of rates staying higher for longer.

There are a lot of businesses out there that are sort of running their balance sheet, which they put in place their strategy a few years back, never having expected to see interest rates go to 5%, let alone stay at 5% for a protracted period of time. So where you do end up with higher for longer, I do think it ends up becoming toxic for leverage, and we have seen things starting to go bad. I have seen examples of private debt funds needing to extend their terms because they can't pay investors their proceeds back, because underlying credits have gone sour.

So we are still starting to see evidence of this, of course, as well. I do have a concern that in some firms you have this sort of rather too cozy for my liking linkage between private credit and private equity in as much as private debt funds are being used to support private equity holdings. Again, I do wonder about conflict of interest in those sorts of situations. But the thing, you know, in terms of the private equity asset classes, the lack of IPO market, the lack of deal flow there again, is really hurting private equity as an asset class at the moment.

A lot of the movement in private assets is from one set of hands to another set of hands within the private asset community. So intrinsically for me this is an area that I'm just fundamentally a bit more concerned about. And I would sort of note again, that I was very, very enthusiastic about the idea of private debt when you were looking at yields of six or seven. But public market fixed income was paying you around zero, as it was in Europe for a long period of time.

But now that you're in a world where public market fixed income delivers you a more attractive coupon, and because threads have come in on private credit, I just really sort of question whether investors need to be sort of pushing the risk envelope in in that way, particularly in an asset class, which obviously doesn't have a lot of transparency and incurs a lot of fee and cost.

I might have time for one last question, any thoughts, expectations for China in its term plenum? So well bluntly on China, a country that gets old before it gets rich is kind of, in my view, sadly on the demographics. I also think the centralisation of power under Xi intrinsically hurts the the potential GDP. So it's one of the reasons the economy is struggling. Furthermore, the political narrative coming out of Washington coming out even NATO last week, you're seeing this disengagement. The world wants to trade less with China. We're seeing sort of tariffs in the EU on electric vehicles, for example. and all of this is occurring at a moment when China is really struck, because it's got this sort of disinflationary outcome because of the housing bubble going bust.

And this has got echoes of what I saw in Japan in the late nineties, and it'll probably take a few years to work your way through. So I struggle to be bullish around the China macro story. I think that sort of China does face a number of challenges, and because it will struggle to reorientate its economy towards becoming more consumerist in the way the US is, for example, and because a lot of countries won't want to just absorb more Chinese imports. I just think that the Chinese economy could sort of struggle, relatively speaking, over the course of the next couple of years.

With that I'm going to close off my comments. Say goodbye to you. It's been a pleasure being here today, even though I've just flown back from Berlin. Having watched my poor England football team lose a tournament once again. So, apart from feeling a bit broken today, I hope those comments have been thought provoking and come across as whole. Nonetheless, thank you for joining and look out for the next one of these. In a month's time.