It’s Always Darkest Before the Light.

An oversold condition in the bond market and then a war in the Middle East two weekends ago have allowed bond yields to ease, providing yet another reprieve for fixed income investors. Many investors have stated that rising bond yields will do the work for the Fed and allow it to stand pat. The Fed highlighted that rising bond yields were helping cool economic growth. Yields then turned abruptly and dropped over the past week partly reflecting expectations that the Fed is finished tightening and will lower rates next year. Central banks have underestimated the inflationary process. Monetary conditions are not yet restrictive enough and unless some economic weak link snaps shortly, we expect higher bond yields and/or policy rates before the next recession develops. We believe that is necessary to generate some economic slack and thus a meaningful and durable disinflationary phase. Both the U.S. and Chinese PMI manufacturing indexes are moving in a positive direction, and any revival in the weak goods sector of the global economy, including trade, would provide a boost to economic sentiment and likely put a floor under goods prices.  If so, our view of sticky inflation and an ongoing global economic expansion will pan out, to the detriment of bond markets. It is uncertain whether the Fed will have to raise rates further, which it clearly prefers not to do, or if the bond market does the Fed’s work via higher long-term yields. Some combination may ultimately occur. At a minimum, next year’s rate cut expectations will likely unwind, putting renewed upward pressure on bond yields. While conditions in the Middle East are still uncertain, it does not seem likely that the war will have a significant impact on the global economic cycle. In fact, the initial market reactions in the past week point to more of the same: risk-on whenever bond yield and Fed rate expectations ease. For equities, the danger of our somewhat guarded bond outlook is that while corporate earnings should provide some support, the larger influence on stock markets over time will be periodic bouts of de-rating whenever bond yields rise. This condition dominated bond market action last year and has repeatedly, but usually only briefly, been evident in 2023. In fact, such an episode was developing before the past week’s abrupt decline in bond yields. It is possible that more such de-rating episodes in 2024 will occur until the economic outlook deteriorates, which will cast a shadow over earnings.  Our investment stance is little changed despite the escalation of global geopolitical tensions. To the extent that the uptrend in bond yields has reversed, it will help to support growth and ensure inflation stays sticky. Valuations in fixed income have improved considerably in the past 18 months, causing us to suggest modest purchases of bonds, especially into weakness. Flat-to-lower bond yields will also allow equities to hold up for a while longer. 3Q earnings and earnings revision activity for 4Q and 2024 are key.