Here are some observations from my recent London trip. 

The timing was great as it allowed me to test two of our new ideas. One, that the US recession is over. And two, that the next big directional move in US 10-year bond yields is still higher towards 5 percent. 

The macro community was decidedly bearish on the US economy and I received a lot of pushback on both views. While many were surprised by the strength of the labor market, incoming positive data did not change their positioning, but rather just shifted their trade horizon.

There is still an expectation that the US economy will deteriorate in the second half of the year leading to higher unemployment. So the thinking was that now’s the time to patiently position for the coming recession: long vol, short stocks, long bonds, and curve steepners. 

But consider this. In the UK, interest rates have a direct effect on discretionary income since most UK mortgages reprice every two years. That means UK homeowners will be spending as much as 30 percent of their income on mortgage payments, up from about 20 percent previously.

In the US, mortgage interest payments as a percentage of disposable income have remained relatively flat, even as mortgage rates have soared. That’s left homeowners in the US fairly insulated from the rate shock. 

So if the UK economy looks to have fared well in the first half of this year, and is expected to steer clear of a recession, why should we expect the US to succumb to one?

Our view is that the recession is already over. This matters because if you think a recession is imminent, you’ll be more cautious and defensive. But if you believe it is over, you’re more comfortable taking risk and extending your time horizon. 

Think of it like this: we saw an economic recovery from March 2020 through March 2022, followed by a nine month recession. And now, starting in January of this year, we are in a new economic recovery.

Typically, we’ve been used to seeing four to six year economic cycles, but this one is going to be shorter because we didn’t actually create any labor market slack in this recession. So it probably only lasts 18 to 24 months.

But this perspective shift is important—that the recession is over rather than delayed—because it leads to a very different set of trades. 

For example, no one is imagining that the 10-year yield could exceed 5 percent. That came as a surprise to me. Maybe it is because it is counter to how everyone is positioned. 

The EM carry trade is popular and has done very well this year. Most EM countries started hiking before the Fed in this cycle, and hiked rates even more significantly so yields are quite attractive. 

For example, Brazil’s central bank started raising rates in March 2021, and went on to hike by nearly 12 percent to the current level of 13.75 percent. And now with the inflation picture changing across Latin America, central banks could soon take the lead in cutting interest rates. 

The Mexican peso has been outstanding, rising 14 percent year to date to its strongest level since 2017. Now, if we imagine a world of 5 percent US 10-year yields, then carry trades risk being unwound. It is where you have the most crowded positioning. That is something to be careful about.

If our view about the US economy is correct, and bond yields move higher, the market will force investors out of the recessionary trades and EM carry positions. The pain trade is higher yields and dollar.  

Another interesting conversation was around real money investors. Given current yields available across the fixed income universe, pension funds can meet their return targets of 7 to 8 percent quite easily by taking less equity risk. And we see this in flows with an overweight in bonds relative to equities.

However, I met with someone who shared that even though it’s never been easier to meet their return targets, the pension funds are still benchmarked in relative terms. So when equities are up more than 20 percent, they look to be seriously underperforming. It’s not enough to meet your return target if you’re lagging to such a degree. 

This makes me think that any pullback in equities will be shallow because institutional participation in this rally remains weak. And that’s likely to change. 

There’s an argument that the dividend and earnings yield on the S&P 500 is well below the risk free rate. So why bother with stocks? Well, from a behavioral standpoint, now you know why. 

And again, if we are moving to a world in which nominal yields will be higher, then weakness in their fixed income book will lead to some reallocation into equities. 

Something else that I found fascinating was the pervasive bearishness on the prospects for UK and Europe. There is this idea that “America is winning” and that will always be the case.  

What’s interesting is that the market is telling you otherwise. Since the October low, the UK stock market is up 25 percent in dollar terms, the S&P 500 is up 26 percent, and European stocks are up 36 percent.          

On a one year basis, the S&P 500 is up 19 percent while European stocks are up 22 percent. This is despite the AI boom, a capex resurgence, and the US running wider deficits. 

Thinking about tech, if climate is the zeitgeist for this decade, then what we need is deep hardware tech, not software. Paris, London and Berlin are better suited than Silicon Valley in that case. So is America really winning? 

It seems we’re holding on to a belief that is just no longer true. I wonder if it will take a raucous US elections season to reveal that we should be diversifying away from the US and US-dollar based investments. 

I’m reminded of Arnold Toynbee’s statement, recalling the 1897 diamond jubilee celebration of Queen Victoria: “Here we are on top of the world. We have arrived at this peak to stay there forever. There is, of course, this thing called history. But history is something unpleasant that happens to other people.”

What if America is facing the unpleasantness of history?

I’ll let you reflect on that.