How to hedge against a possible US recession?

The current financial landscape in the US is characterised by a narrow gap between corporate bond index yields and overnight interest rates, driven by rising rates and narrowing credit spreads. Faced with this situation, Axa Investment Managers believe that there’s a chance to establish hedged positions in anticipation of a possible US recession. 

Chris Iggo, Chair of the Axa IM Investment Institute and CIO of Axa IM Core, contends that resilience is the core of US economy’s performance. According to him, households and businesses have avoided significant cuts in consumption and investments despite challenges such as rising energy and food prices, increased living costs, and higher interest rates post-Covid-19. 

“The most recent quarter was slower but, under the circumstances, this is not a bad outcome – and companies have been able to manage slower growth, higher costs, and increased interest expenses,” said the asset manager. 

Iggo further points out that market behaviour aligns with this macroeconomic narrative, with equities outperforming bonds, growth equities outperforming value, and the US market surpassing global counterparts. In fixed income, he informs that leveraged loans and US high-yield credit have excelled, even outperforming European bonds.

However, Axa warns that credit valuations warrant scrutiny amid fears of an impending US recession. As per the asset manager, the gap between corporate bond yields and the Fed Funds Rate has narrowed, indicating the potential for credit risk premiums to rise as monetary policy tightens.

“A hard landing scenario developing from the current soft-growth patch against the backdrop of a still-hawkish Fed, might suggest shifting away from credit towards relatively less risky government bonds,” said Iggo. 

He subsequently goes on to suggest that reducing equity and high-yield exposure in favour of duration and employing hedges that benefit from rising risk premiums and falling rate expectations could be prudent strategies. 

Additionally, Axa states that a hard landing, marked by behavioural shifts in households and businesses, would prompt market repricing. Meanwhile, in a soft-landing scenario, yields on a credit portfolio are unlikely to significantly undercut overnight interest rates, it added. 

Along with that, Iggo delves deeper into how valuation concerns relative to interest rates in credit can be extended to the equity market. He also stresses the need to pay attention to the El Nino weather phenomenon in the eastern Pacific Ocean, which could disrupt food crops and impact commodity prices.  

Read the full insight here.