purse | Recession: Recession fears set to split stocks and bonds after summer rally

It’s been a summer of love for stocks and corporate bonds. But with the fall approaching, stocks are set to fade while bonds strengthen as central banks tighten reserves and recession fears resurface.

After a brutal first half, both markets were poised for a rebound. The spark was ignited by resilient earnings and hope that a slight cooling in runaway inflation would prompt the Federal Reserve to slow the pace of its rate hikes in time to avoid an economic contraction.

A nearly 12% advance in July and August put US stocks on track for one of their best summers on record. And corporate bonds have gained 4.6% in the US and 3.4% globally since the mid-June low. Having moved in tandem, the two are now poised to diverge, with bonds looking better positioned to prolong the rally as the race for safety in an economic downturn will offset a rise in risk premia.

Agencies

The economic outlook is cloudy again, as Fed officials have signaled they are unwilling to stop tightening until they are sure inflation will not pick up, even at the cost of some ” economic pain, according to Wei Li, global chief investment strategist at BlackRock Inc.

For government bonds, this means a potential flight to safety that would also benefit higher quality corporate debt. But for stocks, it’s a risk to earnings that many investors may not want to bear.

“What we’ve seen at this point is a bearish rally and we don’t want to chase it,” Li said, referring to stocks. “I don’t think we’re off the hook with a month of cooling inflation. Bets on a dovish Fed pivot are premature and earnings do not reflect the real risk of a US recession next year.

Asset classes may divergeAgencies

The second quarter earnings season did much to restore confidence in the health of US and European businesses, as companies largely proved that demand was robust enough to pass on rising costs. And major economic indicators, such as the US labor market, have held up strongly.

But economists predict a slowdown in business activity from now on, while strategists say companies will struggle to keep raising prices to defend margins, threatening second-half profits. In Europe, Citigroup Inc. strategist Beata Manthey predicts earnings will decline 2% this year and 5% in 2023.

And while investors in the latest Global Fund Manager Survey from Bank of America Corp. have become less pessimistic about global growth, the sentiment is still bearish. Inflows into stocks and bonds suggest that “very few people fear” the Fed, according to strategist Michael Hartnett. But he believes that the central bank is “far from having finished” its tightening. Investors will be looking for clues on that front at the Fed’s annual rally in Jackson Hole this week.

Hartnett recommends taking profits if the S&P 500 rises above 4,328 points, he wrote in a recent note. This is about 2% above current levels.

Some technical indicators also show that US stocks will resume their decline. A Bank of America measure that combines the S&P 500 price-earnings ratio with inflation has fallen below 20 before every market low since the 1950s. But during this year’s selling waves, it hasn’t reached only 27.

Stock reboundAgencies

There is one trade that could provide big support for stocks. So-called growth stocks, including tech giants Apple Inc. and Amazon.com Inc., have been seen as a relative haven. The group led the recent stock market rally and strategists at JPMorgan Chase & Co. expect it to continue to climb.

Advantage Bonds

In the bond world, the layers that make up a company’s borrowing costs look poised to play into the hands of investors. Corporate returns include the rate paid on similar public debt and a premium to offset threats like borrower bankruptcy.

When the economy falters, these building blocks tend to move in opposite directions. While a recession will raise concerns about companies’ ability to service debt and widen the spread to safe bonds, the flight to quality in such a scenario will cushion the blow.

“The potential damage to investment grade appears limited,” said Christian Hantel, portfolio manager at Vontobel Asset Management. “In a risk-free scenario, government bond yields will fall and mitigate the effect of wider spreads,” said Hantel, who helps oversee 144 billion Swiss francs ($151 billion).

This advantage of lower public yields in a downturn particularly affects higher-quality bonds, which are longer-term and offer thinner spreads than their junk-rated counterparts.

“There’s a lot of risk and it feels like the list is getting longer and longer but, on the other hand, if you’re underweight and even outside the asset class, you don’t can’t do anything more,” Hantel said. “We’ve been getting more questions about investment grade, which signals that at some point we should get more entries.”

Admittedly, the summer rebound has made corporate bond entry points less attractive for those brave enough to dive back in. tempered its enthusiasm for credit- and rate-sensitive bonds somewhat, as valuations no longer look particularly cheap.

Still, he sticks to the bullish views he first voiced earlier this summer after bond selling pushed yields to levels that could even beat inflation.

“The world was becoming a more bond-friendly place and that should continue into the second half,” he said.

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