Morgan Stanley IM: R.I.P. Cycle, Part 3: Markets, Meet Your (Policy) Maker
Jim Caron, Portfolio Manager and Chief Fixed Income Strategist, shares his macro thematic views on key market drivers.
12.10.2022 | 08:01 Uhr
Risk premia continues to rise as markets price the Fed policy
seriously, namely 4.75% by January 2023, with upside rate risk if
inflation, particularly wage inflation, doesn’t make sufficient progress
R.I.P. (Recession, Inflation and Policy Risk) Cycle: The risk of
Recession and Inflation are occurring simultaneously, but Policy can
only respond to one, not both. If policy chooses to battle inflation,
the casualty will be a higher risk of recession. At this juncture it
will be hard for policy makers not to make a mistake by either over- or
under-tightening, and a mistake can be deadly (R.I.P.)
Good news is unfortunately bad news, in the sense that economic
strength “ups the ante” for more aggressive rate hikes. Mathematically,
Fed rate hikes push discounted future cashflow rates higher, lowering
the present value of asset prices, the reason for the current down draft
in risk assets.
Higher rates and an increased risk of recession go hand in hand,
adversely impacting credit risks and heightening default risks, which in
turn widens credit spreads. As both the cost and risk for credit
increase, the more likely something breaks in the economy, leading a
The “pivot” in policy rates in mid-2023 represents the markets
pricing a bad outcome that forces the Fed to stop hiking or even start
cutting rates. This is the opposite of what Fed officials are saying,
who instead claim they will keep policy rates high for as long as it
takes to get inflation to target. And so begins the R.I.P. cycle.
The labor market becomes a key factor as we try to understand at
what “cost” is the Fed willing to pay in order to get inflation, namely
wage inflation, to target. That cost is measured by the unemployment
rate, which ticked lower to 3.5% on Friday (Oct 7), putting the Fed at
odds with the labor market.
Over the past three months, the economy has produced on average 372k
jobs per month. At this this pace, remaining slack will be fully
absorbed by year’s end, at which point there will be virtually no one
left to hire.
This is why wage inflation is likely to be sticky, which puts more
upward risk on policy rates and that in turn hurts capital. At this
point, labor is winning and capital (i.e. asset prices) is losing, in an
ever steepening uphill battle.
Diversification does not eliminate risk
of loss. There is no assurance that a portfolio will achieve its
investment objective. Portfolios are subject to market risk, which is
the possibility that the market values of securities owned by the
portfolio will decline and that the value of portfolio shares may
therefore be less than what you paid for them. Market values can change
daily due to economic and other events (e.g. natural disasters, health
crises, terrorism, conflicts and social unrest) that affect markets,
countries, companies or governments. It is difficult to predict the
timing, duration, and potential adverse effects (e.g. portfolio
liquidity) of events. Accordingly, you can lose money investing in this
portfolio. Please be aware that this portfolio may be subject to certain
additional risks. Fixed income securities are subject to the
ability of an issuer to make timely principal and interest payments
(credit risk), changes in interest rates (interest-rate risk), the
creditworthiness of the issuer and general market liquidity (market
risk). In a rising interest-rate environment, bond prices may fall and
may result in periods of volatility and increased portfolio redemptions.
In a declining interest-rate environment, the portfolio may generate
less income. Longer-term securities may be more sensitive to interest rate changes. Mortgage- and asset-backed securities
are sensitive to early prepayment risk and a higher risk of default,
and may be hard to value and difficult to sell (liquidity risk). They
are also subject to credit, market and interest rate risks. Certain U.S. government securities
purchased by the Strategy, such as those issued by Fannie Mae and
Freddie Mac, are not backed by the full faith and credit of the U.S. It
is possible that these issuers will not have the funds to meet their
payment obligations in the future. High-yield securities (“junk bonds”) are lower-rated securities that may have a higher degree of credit and liquidity risk. Public bank loans are subject to liquidity risk and the credit risks of lower-rated securities. Foreign securities are subject to currency, political, economic and market risks. The risks of investing emerging market countries are greater than risks associated with investments in foreign developed countries. Sovereign debt securities are subject to default risk. Derivative instruments
may disproportionately increase losses and have a significant impact on
performance. They also may be subject to counterparty, liquidity,
valuation, correlation and market risks. Restricted and illiquid securities may be more difficult to sell and value than publicly traded securities (liquidity risk).
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