Recession Fears Set to Split Stocks and Bonds After Summer Rally

(Bloomberg) — It’s been a summer of love for both stocks and company bonds. But with fall nearing, equities are set to fade while bonds strengthen 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 lit by resilient earnings and hopes that a slight cooling in rampant inflation would get the Federal Reserve to slow the pace of its rate hikes in time to avert an economic contraction.

A near 12% advance in July and August has put US stocks on course for one of their best summers on record. And companies’ bonds have gained 4.6% in the US and 3.4% globally since bottoming out in mid-June. Having moved in tandem, the two are now set to diverge, with bonds looking better placed to extend the rally as the dash to safety in an economic downturn will offset a rise in risk premiums.

The economic outlook is once again cloudy as Fed officials have indicated they’re not keen to stop tightening until they’re sure that inflation won’t 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 debt from investment grade firms. But for stocks, it’s a risk to earnings that many investors may be unwilling to bear.

“What we’ve seen at this juncture is a bear market rally and we don’t want to chase it,” Li said, referring to equities. “I don’t think we’re out of the woods with one month of inflation cooling. Bets of a dovish Fed pivot are premature and earnings don’t reflect the real risk of a US recession next year.”

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The second-quarter earnings season did much to restore faith in the health of corporate America and Europe as companies largely proved demand was robust enough for them to pass on higher costs. And broad economic indicators — such as the US labor market — have held up strongly.

But economists forecast a slowdown in business activity from here on,…

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