Amidst a facade of strength in the U.S. economy, Janus Henderson Investors, based in Denver, has identified signs of a potential fragility that many in the financial markets may not have recognized.
The most potent indicator of headwinds facing the U.S. economy is found in the composition of the 10-year Treasury yield (BX:TMUBMUSD10Y). This includes a significant rise in the inflation-adjusted or real yield, which currently stands at about 2.5%. This represents the highest cost of capital faced by U.S. businesses and households in over a decade, according to Adam Hetts, portfolio manager and global head of multi-asset investing for Janus Henderson.
Real yields reflect the stated return on long-term Treasurys after adjusting for inflation. Higher real yields are advantageous for savers, driving more investors into cash-like vehicles and making riskier options, like stocks, less appealing. This has been a major factor behind the recent surge in the nominal 10-year yield, which surpassed 5% in October and was at approximately 4.6% on Tuesday.
“Importantly, nominal yields have continued to climb even as inflation has subsided,” wrote Hetts in commentary distributed on Tuesday and posted to his firm’s website. “We interpret this as the recognition of a potential regime change in rates.”
Janus Henderson, with $308.3 billion in assets under management, isn’t the only financial institution suggesting the possibility of a more fragile U.S. economy. In late October, Pershing Square’s Bill Ackman and Bill Gross of Pacific Investment Management Co. also made similar forecasts.
In Janus Henderson’s case, the firm is recommending that investors focus on “prioritizing quality companies capable of steady cash flows and possessing sound financials as we enter the later stages” of the current cycle.
Here are more reasons why Hetts sees diminishing hopes for a soft landing by the U.S. economy and what investors can do about it.
Personal savings diminish
“The bulge in personal savings owed to pandemic-era stimulus packages has largely run its course,” according to Hetts. “Furthermore, consumption has more recently been powered by credit cards. With borrowing costs having reset to decade-plus highs, we question American households’ desire — or ability — to keep racking up such purchases.”
Higher-for-longer rates in lots of places
Another reason to doubt the durability of consumption is “our long-held view that policy rates will remain elevated for longer,” with expectations for a pivot by central banks in 2024 becoming “tempered,” Hetts wrote.
“Compounding this risk is our belief that the U.S. economy — and others, for that matter — have yet to feel the full brunt of previous rate hikes,” he said. “Relative to other tightening cycles, we are still in fairly early innings, meaning the curtailment of demand that is the intention of hawkish policy is still working its way through the system.”
Reasons to stay defensive
Unlike fixed income, which has undergone repeated rounds of aggressive selloffs, low-quality corporate bonds have yet to reflect the myriad of risks posed by higher interest rates.
The spread on high-yield corporates and those of risk-free benchmarks “remains below long-term averages,” Hetts wrote. “Our concerns for this segment are compounded by the risk of a harder-than-expected landing, which could stress some of these companies’ leveraged business models.”
Equity returns, decomposed
The risks from higher interest rates and a possible harder-than-expected economic “landing” aren’t being spread out evenly across stocks, with mega-cap technology and internet companies holding up better than the broader market.
“Many of these business models, in our view, are well positioned to weather an economic downturn given their consistent cash flow generation, strong balance sheets, and exposure to durable secular themes,” Hetts said. “Value and more cyclically exposed names, on the other hand, could come under additional pressure in a slowing economy.”
Diversify
Uncertainty over how long interest rates will stay elevated, coupled with geopolitical risks, are clouding the outlook, creating market volatility. That volatility and uncertainty is causing asset classes like stocks and bonds to occasionally move in tandem.
Bonds “have the potential to act as [a] ballast to riskier assets in a broad portfolio,” Hetts said.
On one hand, yields have reached levels that offer attractive income potential and possibly lower volatility if rates stay within current ranges. On the other, should a rapidly weakening economy force central banks to pivot, which is not Janus Henderson’s base case, “bonds’ potential for capital appreciation could offset losses in more cyclically exposed asset classes.”
In a nutshell, bonds are relatively more attractive, with the potential to produce income and “capital generation” in a risk-off scenario.
As of afternoon trading in New York on Tuesday, all three major stock indexes DJIA, SPX, COMP were higher as fixed-income investors looking for stabilization sent 3- BX:TMUBMUSD03Y through 30-year Treasury yields BX:TMUBMUSD30Y down.
