Recession fears will divide stocks and bonds after summer rally

(Bloomberg) — It’s been a summer of love for corporate stocks and bonds. But as the fall approaches, stocks will fade while bonds rally as central bank tightening and recession fears reassert themselves.

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After a brutal first half, both markets were poised for a recovery. The spark was ignited by steady earnings and hopes that a slight cooling in rampant inflation would prompt the Federal Reserve to slow the pace of interest rate hikes in time to stave off an economic contraction.

A nearly 12% advance in July and August put U.S. stocks on track for one of their best summers on record. And corporate bonds are up 4.6% in the U.S. and 3.4% globally after bottoming out in mid-June. After moving in tandem, the two are now poised to diverge, with bonds looking better positioned to extend the rally as the rush to safety in an economic downturn will offset rising risk premia.

The economic outlook is once again murky as Fed officials indicated they are unwilling to end tightening until they are certain inflation will not flare up again, even at the cost of some economic “pain,” according to Wei Li, global chief investment strategist at BlackRock Inc.

For government bonds, that means a potential flight to safety that would also benefit debt from investment-grade companies. But for stocks, that’s an income risk that many investors may not be willing to take.

“What we’ve seen at this point is a bear market rally, and we don’t want to chase it,” Li said, referring to the stock. “I don’t think we’re out of the woods with a month of cooling inflation.” Bets on a Fed pivot are premature and earnings do not reflect the real risk of a US recession next year.”

The second-quarter earnings season did much to restore faith in the health of corporate America and Europe, as companies largely proved that demand was robust enough to pass on higher costs. And broad economic indicators — such as the U.S. labor market — held strong.

But economists forecast a slowdown in business activity from now on, while strategists say companies will struggle to keep raising prices to protect margins, threatening earnings in the second half. In Europe, Citigroup Inc. strategist. Beata Manti predicts a 2% drop in revenue this year and 5% in 2023.

Read more: BofA to JPMorgan cools European stocks after summer rally

And while investors in Bank of America Corp.’s latest survey of global fund managers. have become less pessimistic about global growth, sentiment is still bearish. Inflows into stocks and bonds suggest they have “very little to fear” from the Fed, according to strategist Michael Hartnett. But he believes the central bank is “not done yet” with 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, he wrote in a recent note. That’s about 2% higher than current levels.

Some technical indicators also suggest that US stocks will resume the decline. A Bank of America measure that combines the S&P 500’s price-to-earnings ratio with inflation has fallen below 20 before every market bottom since the 1950s. But during the waves of sales this year, it only reached 27.

There is one trade that could offer major support to the stock. So-called growth stocks, including tech giants Apple Inc. and Inc., are seen as a relative haven. The group led the stock’s recent rally and strategists at JPMorgan Chase & Co. they expect it to continue to rise.

Senior bonds

In the bond world, the layers that make up a company’s borrowing costs look set to play into investors’ hands. Corporate yield consists of the interest rate paid on similar government debt and a premium to offset threats such as borrower default.

When the economy falters, these building blocks tend to move in opposite directions. While a recession would raise concerns about the ability of firms to service their debt and widen the spread on safe bonds, a flight to quality in such a scenario would soften the blow.

“Potential damage to investment grade appears limited,” said Christian Hantel, portfolio manager at Vontobel Asset Management. “In a reduced-risk scenario, government bond yields would fall lower and reduce the effect of wider spreads,” said Hantel, who helps oversee the 144 billion Swiss francs ($151 billion).

This benefit from falling government yields in the event of a downturn particularly affects high-quality bonds, which have longer maturities and offer thinner spreads than junk-rated peers.

“There’s a lot of risk around, and the list seems to get longer and longer, but on the other hand, if you’re underweight and even out of asset class, there’s not much you can do,” Hantel said. “We’re getting more investment grade inquiries, which signals that we should get more inflows at some point.”

Certainly the summer recovery has made entry points into corporate bonds less attractive for those brave enough to take the plunge again. George Bory, head of fixed income strategy at $476 billion money manager Allspring Global Investments and a bond evangelist in recent months, has somewhat tempered his enthusiasm for credit and interest-sensitive bonds as valuations no longer look particularly cheap .

Still, he stuck to the bullish outlook he first expressed earlier this summer after the bond selloff sent yields to levels that could even beat inflation.

“The world was becoming a more relationship-friendly place and that should continue in the second half of the year,” he said.

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