Weekly market commentary

Volatility brews

Bond and equity implied volatility, 2011-2023

A delay in lifting the U.S. debt limit, as well as the euro area debt crisis, spurred a bout of market volatility in 2011. See the chart. U.S. Treasury bill yields seen as the most vulnerable to late payment jumped, and the S&P 500 fell about 17% between July and August 2011. Policy rates were near zero back then, deflation risks were emerging and the Fed balance sheet was expanding. All that provided a cushion. The backdrop is very different today. Bond market volatility has already surpassed the 2011 level (dark orange line) as markets grapple with central banks’ trade-off: either live with some inflation or crush economic activity. Equity volatility is more muted (yellow line). Yet we don’t think stocks have been immune – just a few major tech stocks account for almost all S&P 500 returns this year. Our conclusion: Brace for higher volatility because of the combined effect of debt ceiling concerns and financial cracks from rate hikes.

Invested but cautious

It’s uncertain when exactly the U.S. Treasury will run out of funds to meet its financial obligations – known as the “X date.” Treasury Secretary Janet Yellen has warned that could happen as soon as early June. Conversations about a last-minute deal to raise or suspend the debt ceiling, meaning eliminate it for a brief period, are ongoing as Democrats have so far rebuffed Republicans’ push for spending cuts and other concessions. The Treasury risks a technical default when it temporarily fails to make its bond payments if policymakers don’t strike a deal in time. The Treasury may prioritize paying bondholders over others, but it’s unclear if the Treasury can do so: There is no precedent, and the Treasury lacks the legal authority. Yet there is precedent for credit rating agencies trimming the U.S. top-notch credit rating like S&P did in 2011 – even if a technical default doesn’t happen. That could cause investors to demand more compensation for holding U.S. assets amid higher risk.

Yields for some Treasury bills maturing just after the X date have already started to rise, but risk assets have yet to fully react. Yields for the affected Treasury bills could march higher, and volatility may keep cycling through assets if the debt ceiling is repeatedly suspended.

We stay invested but cautious against this backdrop. We had already been going up in quality and focused on building resilient portfolios as the Fed rapidly hiked rates. We see opportunities to earn attractive income in short-term debt if yields rise more. Investors who don’t need to quickly sell assets can earn attractive income during the debt showdown, in our view, by holding on to at-risk Treasury bills until they mature. Persistent inflation makes inflation-linked bonds attractive, too. Notably, demand for gold has picked up via exchange-traded funds and foreign exchange reserve managers.

Developed market equities remain the bulk of portfolio allocations, even as we underweight them slightly in the short term. We prefer emerging market (EM) stocks in the short term as they benefit from China’s economic restart, EM central banks nearing the end of their hiking cycles and a broadly weaker U.S. dollar. We could consider leaning more into equities overall if debt ceiling volatility and recession create a sharp fall in equity prices.

Our bottom line

The debt ceiling showdown is set to increase the volatility in financial markets that has defined the new regime. Any selloff may cause risk assets to better price in the economic damage we expect from interest rate hikes. We’re ready to shift our views on a six- to 12-month horizon to take advantage of opportunities that may appear.

Market backdrop

Global stocks were largely unchanged last week and bond yields stayed within their range since mid-March. U.S. CPI data showed that core services inflation, excluding shelter, is easing, but core goods prices surprisingly ticked higher. Core inflation still doesn’t look on track to settle near the Fed’s 2% target, making Fed rate cuts this year unlikely, in our view. The Bank of England hiked policy rates to 4.5% as it carries on with its fight against stubborn inflation while growth stagnates.

We’re watching industrial production and business survey data in the U.S. to gauge the damage to activity as higher interest rates tighten financial conditions and cause financial cracks, as seen in bank turmoil. We’re also looking for signs of a sustained rise in Japan inflation that we think may eventually spur a change in ultra-loose policy – and bond volatility.

Directional views

Strategic (long-term) and tactical (6-12 month) views on broad asset classes, May 2023

Our granular views indicate how we think individual assets will perform against broad asset classes. We indicate different levels of conviction.

Tactical granular views

Six to 12-month tactical views on selected assets vs. broad global asset classes by level of conviction, May 2023