Decoding mixed messages in the market

Potential for high-quality credit to outperform other asset classes

While risk assets were able to shake off the highest government bond yields this cycle in August, we believe that it is prudent to be cautious, as we are most likely late in an economic cycle. The late August rally was reminiscent of 2021, when the market had taken an optimistic view that inflation would prove to be transitory. The S&P 500 closed August at almost the exact same level as it did two years ago: 4,508 in 2023 compared with 4,523 in 2021. In some ways, risk markets could be even further ahead of themselves now than they were two years ago.

While inflation turned out not to be transitory, to support asset prices now, we believe that both a soft landing and lower rates are required. It seems unlikely to us that both will be achieved, with the possibility that neither a soft landing nor lower rates is also a realistic scenario.

We do not believe that valuations in large-cap public equities, private markets, and real estate have appropriately adjusted to a higher interest rate regime. While credit spreads are not cheap by any means, the impact of much higher base rates than the post-Great Financial Crisis era is reflected in prices. Over the medium to long term, there is a good prospect for high-quality credit to outperform other asset classes, mostly driven by the significant carry advantage.

In the short-term, divergences between other asset classes and credit markets can and have persisted for much of this year, but we believe that ultimately, risk premiums will revert to where they should be. We expect this repricing to be choppy and present opportunities to provide liquidity to motivated sellers at some point in the coming quarters.

Warning signs

There are several warning signs present in markets today. One is risk assets responding positively to both good and bad economic news, which suggests a relatively high level of complacency about macroeconomic risks. Secondly, we have seen some high profile “perma bears” turn bullish, which can be a sign of capitulation, which happens close to market peaks. On July 31, Mike Wilson of Morgan Stanley, who had largely been staunchly bearish for the past two years, turned tactically bullish, comparing the current market run to 2019. As of the time of writing, July 31 was the highest close of the year for the S&P 500. Time will tell if Wilson capitulated at the local high.

Following two months of decreasing risk premiums and volatility, both picked up in August. At the end of July, the S&P 500 index had not had a one-day loss of more than 1% since May 23, while there were three days where the index lost more than 1% in August. Despite the increase in volatility as well as government bond yields, risk assets finished the month relatively unchanged, perhaps helped by limited engagement late in the month.

We expect capital market activity to pick up significantly in September, which could reprice credit markets that benefitted from a strong technical, partially driven by a lack of new issuance in the second half of August. In our view, there is a negative skew to asset prices over the near term, and we are positioned accordingly.

Justin Jacobsen, CFA, is the Portfolio Manager of the Pender Alternative Absolute Return Fund. PenderFund Capital Management. Excerpted from the Pender Alternative Absolute Return Fund Manager’s Commentary, August 2023. Used with permission.

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