Morgan Stanley IM: R.I.P. Cycle, Part 3: Markets, Meet Your (Policy) Maker

Fixed Income

Jim Caron, Portfolio Manager and Chief Fixed Income Strategist, shares his macro thematic views on key market drivers.

12.10.2022 | 08:01 Uhr

Jim Caron-10-10-22
Jim Caron-10-10-22

  • 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 to target.
  • 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 “hard landing.”
  • 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.

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See below for important disclosures.

Risk Considerations

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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