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This time is not different
“What we learn from history is that people don’t learn from
history” might just be our favourite quotation from the great
Warren Buffett, as we watch history repeat itself yet again this
In the past 18 months, we’ve seen one of the most aggressive
coordinated hikings of global rates in recorded history. Now
that we’re (finally) reaching the end of the tightening cycle, we
might be tempted to conclude that this time is different and
that the resilience of the coincident macro indicators means a
soft landing is a shoo-in. Even the Fed staff took the recession
call off the table1, citing the “resiliency of the economy”, and
Fed Chair Jerome Powell went so far as to opine that the Fed
sees “the beginnings of disinflation without any real costs in
the labour market.”
We agree that the recent data points are more resilient than
expected and that no dashboard will likely be flashing
recession red in the coming quarter. Even so, our approach as
students of history suggests that we should remain cautious, now more than ever, and avoid the temptation of looking at
the economy through rose-tinted glasses.
For example, the pace of U.S. GDP growth in the second
quarter of 2023, with the latest revisions, stood at 2.6%.
Interestingly, the same quarterly pace of GDP growth was
observed precisely before the 2008-2009, 2001 and 1948
recessions. The very quarter before the 1969-70 recession?
Quarterly growth of 2.7%. How about the 1960 recession?
We all know that monetary policy operates with long and
variable lags (see our previous discussions on the topic here).
We also know that human beings are, by nature, impatient.
This cocktail tends to cause history to repeat itself over and
over. Indeed, headlines about a soft landing tend to spike
when the Fed is done tightening but right before the impact of
the hikes works its way through the economy.
Lost within the soft-landing narrative is the fact that the
breadth in the number of countries and U.S. sectors showing
growth continues to deteriorate. In investment, keeping an
open mind is crucial, but so is paying attention to the data.
Until we start to see growth leaders emerge, our outlook will
It's not about inflation anymore…
Central bankers’ fight against inflation is well under way and,
unless we’re surprised by a premature pivot by the major
players or another inflationary shock, it will most likely be over
by the end of 2024.
Our focus is no longer on the monthly inflation data points, or
even on whether the Fed, the Bank of Canada or the European
Central Bank will raise rates again this year, but rather squarely
on the cumulative impact of the hiking cycle and the signals
our leading indicators are giving for 2024.
Citi’s economic and inflation surprise indices are signaling that
inflation surprises have generally turned negative, with the
United Kingdom, Norway, Sweden and Canada being
The recent dynamics of growth and price pressures point to a
continued fall in global inflation. As can be seen below, the
growth/inflation cycle is now firmly in the economic
slowdown/fading inflation quadrant. With our leading
indicators pointing to even softer global growth, it’s
reasonable to expect both inflation and growth to moderate.
We also find it noteworthy that the resilience of U.S. GDP
growth hinges in large part on consumer spending and fiscal
Above all, we think the depletion of U.S. consumers’ excess
savings, which could dry up by early 2024, is largely responsible
for the sizable positive surprises of 2023. The end of the
moratorium on student-loan repayments, which many
estimate at $18G a month, or more than $50 billion a quarter,
could cause U.S. consumers to change their spending habits
abruptly and stop GDP growth in its tracks.
The unending growth in the U.S. fiscal deficit is also at play
here, and the fiscal thrust is a factor that has a clear expiration
In the first 10 months of the current fiscal year, the U.S. budget
deficit hit $1.6 trillion, more than double the year-ago figure.
Interest payments, on a 12-month running total, have almost
doubled to about $650G.
The downgrade from Fitch is due to these figures; even so,
we’re not overly concerned that the U.S. government will
default on its debt, given that the US dollar serves as the
world’s primary reserve currency. Nevertheless, we think the
steps that will soon be necessary to curb the deficit may
transform fiscal spending from a growth tailwind to a
Will China come to the rescue? Not this time!
This year’s wildest of wildcards, which unfortunately turned
out to be a measly two of spades, was China’s reopening.
Many investors had high hopes that the post-COVID reopening
of the Chinese economy would jolt the global macro cycle;
however, as we argued earlier this year (see here), the timing
was largely unfavourable because global demand for
manufactured goods was contracting.
Since China abruptly ended its zero-COVID policy on January 8,
the news flow has been, to say the least, lackluster. In addition
to Evergrande, whose saga began back in 2021, more property
developers face the risk of going under (Country Garden being
the latest example), cities are struggling with trillions of dollars
of accumulated debt2 and some shadow banks are threatening to default, which could, as we learned in 2008, lead to an
unpredictable chain reaction in the Chinese financial system.
Though the resolution of these financial issues remains a
matter of conjecture, it’s worth noting that the hard macro
data reveal increasing weakness across various facets of the
Chinese economy. We already know that construction starts
and property sales have been contracting since President Xi’s
housing reform was enacted pre-COVID (remember Xi’s words
that started the reform: “houses are for living in, not for
speculation”). And now the macro weakness is spreading to
retail sales, car sales and fixed-asset investments. Exports are
also suffering from weaker global demand, and imports are in
a slump, as evidenced by the bellwether of South Korea’s
exports, which are down almost 20% year over year.
China’s impact on the global economy and markets can be
better captured through its credit cycle, which is a solid leading
indicator of both the global economic cycle and the relative
performance of global stocks versus bonds. Even though
Chinese authorities are enacting some marginal measures to
help keep the credit cycle going (while also supporting the
yuan through open-market operations), the base case is that
the credit impulse will continue to fade in the coming months,
with sizable impacts on global growth and risk appetite.
Emerging countries are where it actually is
different this time
Interestingly, central bankers in some emerging countries,
such as Brazil and Chile, have started cutting their leading rate
as inflation surprises have turned largely negative, which
explains the bottoming behaviour of our global monetary
policy cycle indicator.
Fact is, Brazil and Chile started raising interest rates earlier
than the Federal Reserve and the Bank of Canada, and did so
very aggressively because their economies are more affected
by changes in food prices. The Central Bank of Brazil also had
some extra motivation to curb inflation early: it became
independent in the past year and does not have a history of
being able to tame price pressures.
Previous episodes of sizable Fed tightening preceded
destabilizing currency devaluations in emerging markets, even
leading to sovereign debt and banking crises in Latin America
and Asia. A recent study by the Federal Reserve Bank of Dallas3
shows that, during the current cycle, emerging-market
authorities have taken proactive measures, such as raising
interest rates and improving fiscal discipline, to insulate their
economies against capital flow shifts.
During this latest tightening cycle, emerging-market currencies
have depreciated only modestly, while advanced-economy
currencies have depreciated more. Factors contributing to the
relative strength of emerging-market currencies include early
policy rate increases and the adoption of policies such as
inflation targeting, leading to greater transparency and
credibility in monetary policy.
In the 1980s and 1990s, nearly all emerging-market public debt
held abroad was denominated in foreign currencies, making
these economies vulnerable to periods of home-currency
instability and high inflation; however, the situation has taken
on a more domestic tilt over the past two decades.
Finally, emerging-market economies also hold stronger
foreign-currency reserves – liquid assets – to mitigate the
impact of capital outflows, thus enabling them to finance
current account deficits and roll over maturing debt. All the
above factors amount to a pretty different risk profile for
emerging countries this time, proving that, in the end,
sometimes some things are indeed different.
What do we make of all this?
First, there are too many signs that monetary policy effects are
working their way through the economic machine for us to join the herd and call for a soft landing. The Fed does not have a
solid track record of sticking the landing4, and the magnitude
and speed of the recent tightening cycle are enough to keep us
Second, we’re always asking the question “Where will growth
come from?” But the answer remains awfully hard to find. It’s
almost never “different this time”; things simply unfold with a
different sequence and pace. But we have good reasons to
expect any slowdown not to be too severe, especially when we
consider the great progress that emerging countries have
made to prevent their economies from bearing the brunt of
the global monetary policy cycle.
Our overall positioning has not changed this month, although
we do see a window opening for an attractive alpha trade in
The story so far this year has been the outperformance of U.S.
tech stocks, more precisely the “magnificent seven” with a
connection to the AI theme (Alphabet, Amazon, Apple, Meta,
Microsoft, Nvidia and Tesla). Even though it’s always a risky
strategy to get in front of such strong momentum, we’ve seen
these names reverse some of their gains since late-July,
opening the door to a convergence play.
When looking at the index level, we note that concentration
has recently reached historical highs as the top 10 names in the
S&P 500 weigh about 32% of total market cap; consequently,
the outperformance of the S&P 500 Index relative to its equally
weighted version has jumped to levels seen only in the March
2020 episode and during the dot-com bubble of 1998-2000.
We have thus put in place a tactical trade, going long energy
and short technology, in order to benefit from the rotation
from technology (growth) to energy (value). The relative performances of these two sectors have mirrored each other
so far in 2023, making energy a good candidate for a pair trade.
There are a few catalysts for such convergence. Real 10-year
U.S. yields are getting close to 2%, the highest level since the
GFC; but, what is more important, this level represents a move
of about 3% since the lows reached in early 2022 and is putting
ample pressure on the valuation of growth stocks.
More specifically, we also see that, since the July peak, breadth
(measured by the percentage of names trading above their 50-
day moving average) has sharply deteriorated in the tech
sector but has jumped to 100% in the energy sector.
At the index level, we’ve seen further expansion of multiples
globally over the past 3 months, coupled with upward revisions
to next-12-months (NTM) earnings growth in most regions.
Although most regions have seen earnings growth
expectations fall over the past year, we would remain careful
before upgrading the prospects for earnings until we have
more clarity about the diffusion of monetary policy.
Looking at alternatives to equities, or risk assets in general, we
think it is abundantly clear that the competition has become
more serious, and that the bar for allocating funds to common
stocks is getting ever higher.
As previously discussed here, cash now yields north of 5%
annualized, with almost zero risk. The attractiveness of money
market funds thus needs to be considered when asset allocation decisions are made. As a matter of fact, the total
assets of U.S. money market funds continue to grow, now
surpassing $5.5 trillion, with inflows of $1 trillion in the past 12
In terms of cross-asset valuation, the equity risk premium
(ERP) measured with the 3-month rate is now in negative
territory and shows that equities are now the most expensive
they have been relative to cash since the bursting of the dotcom
bubble. Even though this valuable metric went much
lower before that bubble burst, it does suggest that the
relative upside of equities has become historically limited.
In short, what is clearly different now versus the post-GFC
period is that the list of compelling safe assets has become very
long. We’re in a situation opposite to the “there is no
alternative” (TINA) era, namely a new era of “there are plenty
of alternatives”, or TAPA, when investors are incentivized to
look at alternatives to stocks.
The past few months have seen a sizable selloff in yields, which
has wiped out most of the cumulative year-to-date returns on
the main bond indexes.
Our estimates suggest that all three of the basic building blocks
have been at play: higher growth expectations given the
traction of the soft-landing narrative; a rebound of inflation
expectations as displayed by breakevens; and rising
expectations of higher-for-longer rates as reflected in the risk
The move was especially large in 30-year yields on both sides
of the border, putting further pressure on other asset classes,
because you can now lock in a long-term yield of close to 4.5%
by lending money to the safest borrowers in the world.
Intriguingly, the markets did not react kindly when long rates
reached similar levels in 2022 but seem to be tolerating them
Even though recent market action has been detrimental to a
long-duration position, our macro view continues to suggest
that the next major move in sovereign yields is down.
So, is a Treasury rally still in the cards for the second half of
2023? Timing is always tricky in momentum-reversal trades,
but the balance of risks remains conducive to adding duration
As noted above, real yields are high by historical standards,
providing an attractive stepping stone for long-term expected
returns on Treasuries. The rapid move higher of nominal rates
has also triggered oversold signals on Treasuries, suggesting
potential exhaustion of the recent trend. To see rates reverse
course and move lower, we will most likely need to see a string
of disappointing news on the U.S. labour market and consumer
spending, as well as signs that the scenario of resilient growth
and disinflation is losing some luster.
As the cumulative Fed tightening has yet to have its full impact,
a valid question is “Did the Fed tighten enough?” In technical
terms, we need to compare the real fed funds rate (deflated
by the 10-year breakeven inflation rate) with the Fed’s own
estimate of the neutral real rate, commonly called R-star.
Looking at the current picture, we see that the real fed funds
rate is significantly higher than R-star, and that monetary
policy is the most restrictive it has been since the mid-1990s
(or since we have data on breakeven 10-year inflation). This is
also reflected in the shape of the yield curve, which is the most
inverted over the same period.
A different analysis would be to look at the message from the
well-known Taylor rule. Here, for every major version of the
rule that we use, the message is that it would be warranted to raise rates some more, given the state of inflation and the
labour market, but that the Fed is still mostly there. Remember
that the Taylor rule is a fast-moving guide to how the Fed
should set its policy, and that it would be impractical for the
FOMC to be as reactive as the rule suggests.
Thus, it appears that monetary policy is indeed quite
restrictive, and the language from the Fed suggests that the
tightening cycle is nearing the end. Historically, the peak in 10-
year Treasury yields has tended to coincide with the peak for
the fed funds rate expectations. We think the Fed is at most
one or two hikes away from the end of its cycle, and that the
current level of rates offers an attractive entry point for a core
position in any portfolio.
Commodities and FX
We continue to hold a positive view on commodities in general
and expect that this asset class will outperform U.S. equities by
Our main argument is that commodity prices have pulled back
significantly over the past year as the global economy lost
momentum but seem now to have found a floor, and that their
pricing contrasts sharply with the valuation of U.S. equities.
According at rough estimates, the current pricing of the
Bloomberg Commodity Index (BCOM) seems consistent with
about 60% odds of a recession in the coming 12 months,
compared with only 20% for U.S. stocks. Such significant gaps
open the door to attractive relative trades; a long commodities / short U.S. equities trade could offer positive returns,
regardless of whether the landing is hard or soft.
Looking at crude oil, we see that the widespread
underinvestment in capacity during the COVID period
continues to put a floor underneath prices. As for U.S.
production, the number of active rigs slipped once again in the
past few months, suggesting that the price of WTI could
resume rising in an undersupplied market. Saudi Arabia’s
decision in early August to extend production cuts of a million
barrels a day should also add support for global prices in the
Finally, the U.S. dollar has continued to strengthen against the
major currencies over the past month, as U.S. economic
surprises remain better than in Europe. We expect the
momentum of U.S. data to face headwinds in the second half,
so we could see the greenback resume its downward trend
and, consequently, the Canadian dollar rebound in the coming