(Bloomberg) — It was a summer of love for stocks and corporate bonds. But with the slump looming, equities are likely to fade as bonds strengthen as the central bank tightens and recession fears set in once again.
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After a brutal first half, both markets were poised for a comeback. The spark was ignited by resilient earnings and he hopes that a slight cooling in rampant inflation will prompt the Federal Reserve to reduce the pace of its rate hikes in time to avoid an economic contraction.
A jump of nearly 12% in July and August has put US stocks on track for one of their best summers on record. And corporate bonds have gained 4.6% in the US and 3.4% globally since bottoming out in mid-June. Having moved in tandem, the two are now likely to diverge, with bonds looking better positioned to extend the rally as the race to safety in an economic downturn will offset a rise in risk premiums.
The economic outlook is cloudy again, as Fed officials have indicated they are not willing to stop tightening until they are certain that inflation will not rise again, even at the cost of some economic “pain,” according to Wei Li. Chief Global Investment Strategist at BlackRock Inc.
For government bonds, that means a potential flight to safety that would also benefit investment-grade corporate debt. But for stocks, it’s a risk to earnings that many investors may not be willing to bear.
“What we’ve seen right now is a bear market rally and we don’t want to chase it,” Li said, referring to the stocks. “I don’t think we’re out of the woods with a month of cooling down in inflation. Bets on a dovish Fed pivot are premature and the gains do not reflect the real risk of a U.S. recession next year.”
The second-quarter earnings season did much to restore faith in America’s and Europe’s corporate health as companies amply proved that demand was robust enough to pass on higher costs. And broad economic indicators – such as the US labor market – held up strongly.
But economists expect a slowdown in business activity from now on, while strategists say companies will struggle to keep raising prices to defend margins, threatening second-half profits. In Europe, the strategist at Citigroup Inc. Beata Manthey sees profits falling 2% this year and 5% in 2023.
Read more: BofA to JPMorgan Cool on European equities after summer rally
And while investors in the latest Bank of America Corp. have become less pessimistic about global growth, sentiment is still bearish. Inflows into stocks and bonds suggest that “very few fear” the Fed, according to strategist Michael Hartnett. But he believes the central bank is “not even close to ending” the tightening. Investors will be looking for clues on that front at the Fed’s annual meeting in Jackson Hole this week.
Hartnett recommends taking profits if the S&P 500 rises above 4,328 points, he wrote in a recent note. This is about 2% higher than current levels.
Some technical indicators also show that US equities will resume declines. A Bank of America measure that combines the S&P 500’s price-earnings ratio with inflation has dropped below 20 before every market low since the 1950s. But during this year’s sell-off, it only hit 27.
There is a trade that could offer great support to stocks. So-called growth stocks, including tech giants Apple Inc. and Amazon.com Inc., have long been seen as a relative paradise. The group led the recent rally in equities, and strategists at JPMorgan Chase & Co. hope it keeps going up.
In the world of bonds, the layers that make up a company’s borrowing costs seem ready to play into the hands of investors. Corporate earnings comprise the fee paid on similar government debt and a premium to offset threats such as a borrower’s bankruptcy.
When the economy falters, these building blocks tend to move in opposite directions. While a recession raises concerns about companies’ ability to service their debt and widen the spread on safe bonds, the flight to quality in such a scenario will cushion the blow.
“The potential damage to investment grade appears limited,” said Christian Hantel, portfolio manager at Vontobel Asset Management. “In a risky scenario, yields on government bonds will fall and lessen the effect of wider spreads,” said Hantel, who helps oversee 144 billion Swiss francs ($151 billion).
This benefit of falling government yields in the event of a downturn particularly affects high-grade bonds, which have longer dates and offer lower spreads than higher-rated bonds.
“There is a lot of risk around and it seems like the list is getting longer and longer, but on the other hand, if you are underweight and even outside the asset class, there is nothing else you can do,” he said. Hantel. “We have been getting more inquiries about investment grade, which signals that at some point we should get more inflows.”
To be sure, the summer rally has made entry points into corporate bonds less attractive to those brave enough to come back. somewhat tempered their enthusiasm for credit and rate-sensitive bonds, as valuations no longer seem particularly cheap.
Still, he maintains the upbeat views he first expressed earlier this summer after bond sales sent yields soar to levels that could even outstrip inflation.
“The world was becoming a friendlier place and that should continue into the second half of the year,” he said.
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