Recession fears are expected to split stocks and bonds after the summer rally

(Bloomberg) — It’s been a summer of love for both stocks and corporate bonds. But with the fall looming, stocks are set to weaken while bonds rally as central bank tightening and recession fears take hold once again.

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After a brutal first half, both markets were primed for a rebound. The spark was ignited by resilient earnings and hopes that a slight easing in runaway inflation would prompt the Federal Reserve to slow the pace of its rate hikes in time to stave off an economic contraction.

A nearly 12% gain in July and August put US stocks on track for one of the 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 will now diverge, with bonds looking better positioned to extend the rally as the shift to safety in an economic downturn offsets rising risk premiums.

The economic outlook is once again murky as Fed officials said they are unwilling to stop tightening until they are sure 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 investment-grade debt. But for stocks, it’s a risk to earnings that many investors may be reluctant to take.

“What we have seen at this juncture is a bear market rally and we don’t want to chase it,” Li said, referring to stocks. “I don’t think we’re out of the woods with a month of cooling inflation. Bets on an unnecessary 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 demand was strong enough to pass on higher costs. And broad economic indicators — such as the U.S. labor market — remained strong.

But economists are predicting a slowdown in business going forward, while strategists say companies will struggle to keep raising prices to defend margins, threatening second-half earnings. In Europe, strategist Citigroup Inc. Beata Manthey sees earnings falling 2% this year and 5% in 2023.

Read more: BofA to JPMorgan Cool on European stocks after summer

And while investors in Bank of America Corp.’s latest global fund management survey have become less pessimistic about global growth, the mood is still bearish. Inflows into stocks and bonds suggest “very few fear” the Fed, according to strategist Michael Hartnett. However, he reckons the central bank is “far from done” with tightening. Investors will be looking for clues on that front at the Fed’s annual Jackson Hole meeting this week.

Hartnett recommends taking profits if the S&P 500 climbs above 4,328, he wrote in a recent note. This is about 2% higher than current levels.

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

There is a trade that could provide major support to the stock. So-called growth stocks, including tech giants Apple Inc. and Amazon.com Inc. have been considered a relative refuge. The group led the stock’s recent rally, and strategists at JPMorgan Chase & Co. they expect it to continue to rise.

Advantage bonds

In the bond world, the levels that make up a company’s borrowing costs appear ready to play into the hands of investors. Corporate yields include 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 companies to repay their debt and widen the spread on safe-haven bonds, the 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 risk scenario, government bond yields will come down and reduce the impact of wider spreads,” said Hantel, who helps oversee 144 billion Swiss francs ($151 billion).

This benefit from falling Treasury yields in the event of a recession affects highly rated bonds in particular, which have longer maturities and offer narrower spreads than junk-rated bonds.

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

To be sure, the summer rally has made entry points into corporate bonds less attractive for those brave enough to re-enter. somewhat tempered his enthusiasm about credit-sensitive and interest-rate bonds, as valuations no longer look particularly cheap.

Still, he maintains the bullish views he first expressed earlier this summer after a selloff in bonds drove yields to levels that could even outpace inflation.

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

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