So Why Are Markets So Chipper Lately?
Even without much to go on from the Fed, investors seem to have turned slightly more optimistic over the past month. The S&P 500 Index is more than 8% above its mid-June lows, spreads on corporate bonds have narrowed and outflows from the municipal bond market have finally ceased.
This hopeful tone has set in despite generally disappointing economic data (the U.S. labor market and consumer spending are significant exceptions here) and the dual threat of geopolitical shocks and looming monetary tightening.
The best explanation for the synchronous rally is that markets, like us, do not believe a severe U.S. recession is likely even if policy tightens a bit more from here. A slowdown in economic growth is inevitable at this point, but strong private sector balance sheets and surprisingly persistent hiring growth should prevent a steep rise in unemployment.
Of course, there are some conflicting opinions about this, which we can see from the recent drop in the 10-year U.S. Treasury yield. This, coupled with the hawkish Fed posture, has inverted the yield curve, a traditional harbinger of recession. Fed funds futures markets, left to their own devices in the absence of forward guidance, are pricing in another 100 bps of rate increases from the Fed by the end of the year followed by a few cuts starting in the first half of 2023. This path could help stabilize the economy, but it assumes that inflation will abate and allow the Fed to focus more squarely on growth.
In our base case, market returns should continue to improve from here. But we recognize that further upside inflation surprises and the policy response they would invite pose risks to this view.
As such, we are relatively conservative in our asset allocation posture, with preferences for U.S. high yield credit over equities and a strong overweight to high quality municipal bonds. Investors looking for a way to play our base case for softer growth without a severe recession should consider quality growth stocks, which have been beaten up by the interest rate cycle this year.
Brian Nick is chief investment strategist at Nuveen.