The world’s largest active bond house is warning that, despite last week’s declines, stock markets are still too optimistic about the ability of central banks to stave off a recession.
This recession, says Pimco’s global strategist Gene Frieda, is the most anticipated of all time, but it is indeed coming. He believes that the optimism in the stock market is premature: “Markets are still pricing in interest rate cuts too soon,” the strategist tells Investment Officer.
Interest rate cuts
The prices of Fed funds futures, which reflect investors’ interest rate expectations, indicate that the market expects an interest rate rise of 34 basis points to the peak of the rate hike cycle. This is 10 basis points higher than at the beginning of the month.
Although investors are thereby getting closer to the hawkish expectations of the Federal Reserve, the market finds the expectations of two or more increases that are expected by a large majority of the Fed board, according to Fed Chairman Jerome Powell, to be excessive.
Last week, markets worldwide fell after better-than-expected jobs figures stoked investors’ concerns about the interest rate path. Nevertheless, global stock prices are still firmly in the green this year.
The MSCI World Stock Index has risen by over 12 percent this year. The Nasdaq Composite even had the best start to the year in four decades.
Goldilocks
Stock investors are optimistic about a so-called “Goldilocks scenario,” where the current interest rate plus a few dozen basis points will sufficiently lower inflationary pressure without losing economic activity.
The U.S. labor market appears robust in particular. Last week, U.S. payroll processor ADP reported more new jobs in June than expected: 497,000 compared to the expected 225,000.
According to the official labor market report presented on Friday, only 209,000 jobs were added last month, which is less than the expected 230,000 and also less than the 306,000 in May. The rise in hourly wages is slowing down on average, but wages still rose more strongly than expected in June: 4.4 percent on an annual basis, while 4.2 percent was expected.
This sparked some concerns about interest rates, as the globally declining stock prices suggested, but according to Frieda, most stocks are still too expensive.
Recession
According to him, stock investors overlook the fact that persistently high interest rates will ‘punch a hole in the balance sheets of companies’ that currently still look good. Problems arise when companies have to refinance, according to the strategist. He finds the American optimism startling.
Pimco does not rule out that U.S. inflation will not fall below 4 percent in the medium term. Central banks will have to keep their foot on the brake to drive out excess inflation, resulting in a recession. According to Frieda, earnings per share drop about 15 percent during a recession.
“Stock markets typically only react when the recession is already at the front door, and that’s a risk you don’t have to take as an investor right now. Investors are not being adequately compensated for the risk they are currently taking on stock markets. We believe there is good return to be made at the front end of the yield curves of high-quality government and corporate bonds,” explains Frieda.
To become positive again about stocks, credit ratings of companies must first go down, according to the strategist.