Signals from interest rate futures markets suggest investors expect another 1.75% of interest rate rises in 2022. We see this as something of an upper bound. It’s above Fed members’ current estimate of the long-term neutral rate and, historically, if short-term rates exceed the neutral rate (a theoretical level consistent with a stable, fully functioning economy) we tend to get an economic contraction. Not something the Fed is clamouring to bring about. Still, it’s not nominal rates, but real rates that matter – the path of inflation is very important too. We’ll be keeping a close eye on the evolution of real rates.
Yielding to uncertainty
Because we believe it’s more likely than not that the US economy will avoid recession, we think the 10-year US Treasury yield – an important benchmark of global financial conditions – could continue to rise. Especially given all the ongoing uncertainty around inflation, as well as the central bank’s unwinding of the trillions of dollars of bond purchases it made as part of its quantitative easing programmes. The Fed was the second biggest lender in 2021, purchasing $1.5 trillion of Treasuries and bonds backed by bundled mortgages.
But there is a case that says Treasury yields won’t rise any further from the current 3.0% level. After all, they have already increased by the same amount that they have done on average in complete historic tightening cycles. And core inflation has likely peaked. The balance of probabilities suggests to us only a small rise in US Treasury yields from here.
It’s worth re-emphasising the growing contrast between the monetary policy outlook in the UK and that of the US. Changes in government spending and taxation are a bigger headwind in the UK than in the US. Meanwhile, the cost-of-living squeeze appears more intense in the UK and British households didn’t accumulate savings to the same extent during the acute phase of the pandemic. Consumer confidence in the UK has also plunged recently, and there have been some worrying signs of weakness in consumer-related data like retail sales and new car registrations. In contrast, consumer confidence in the US has stabilised in the past couple of months. With all of that in mind, we think the Bank of England is more likely than the Fed to stop tightening sooner than investors expect. Because of this we are more constructive on UK gilts than we have been for a very long time.
UK aside, this may sound rather optimistic but, to repeat, there is an unusual level of uncertainty in our projections. We may need to see a few months of tamer inflation before sentiment turns.
Looking for the peak
If we look at local peaks in inflation in 1970, 1975, 1980 and 1991, US equities rose significantly in the 12 months that followed every time, delivering a greater than 10% return on average. Even though there were far more reasons back then to worry about the state of the economy and the likelihood that very high inflation was embedded than there are today (see why we think a rerun of 1970s price spirals is unlikely).
But we’re not there yet. Core inflation in the US fell from 6.5% in March to 6.2% in April. However, the month-on-month increase in core prices was much higher than consensus forecasts, driven largely by broadening inflation in the services sector. Core goods prices did not increase at all over the month, which is good news. Faced with a real income squeeze, consumers are prioritising hospitality and travel, while cutting back on supply-constrained consumer goods that they spent an outsized amount on over the last two years. Coupled with sky-high retail inventories and easing domestic logistical bottlenecks, this spending shift to services should mean that core goods inflation falls back from 12% in Q1 towards zero by year end. Factory-gate prices of consumer durables and electronics in China were unchanged on the month, also hugely encouraging news for slowing global inflation. Disruption to the global supply of consumer goods appears remarkably limited despite widespread lockdowns in China as the dynamic zero-COVID strategy continues. Normally, goods inflation is zero-to-negative. A fall back towards that norm will take a good few percentage points out of core inflation by year end, even as services inflation edges higher. Still, to repeat, we’re not there yet.
To sum up, we expect market volatility to continue, but because a global recession appears unlikely within the timeframe to which equity investors react, we continue to believe staying invested in stocks is warranted. Still, growth is slowing, and we think the probability of recession is a far-from-insignificant 30%. We have three approaches to our equity strategy: we want high-quality balance sheets and high or stable profit margins, flexibility to adjust for rising fixed costs and clear pricing power. There are some attractive valuations in ‘quality growth’ stocks now and they are worth looking at. But to balance out any leanings towards quality growth, we also want ‘value’ stocks – those whose earnings or valuations benefit from higher inflation, higher commodity prices or higher interest rates. And finally, we want structural, thematic investments that move independently of economic cycles to hedge against a period of stagnant growth. Stocks related to cloud computing or more efficient and sustainable construction, for example.
Since 2021, bond prices have tended to fall on the days when equities suffered their largest falls. Because of this breakdown in the traditionally inverse relationship with stock prices, we must have significant exposure to other diversifying strategies to protect our portfolios. These strategies have been a bedrock of our approach to asset allocation for over a decade.
Keeping an open mind
But what if we’re wrong? What if a recession does occur within the next six to 12 months?
How to position for that will depend on what happens to inflation. In a classic recession, falling private-sector spending and investment tend to be the dominant forces, dragging down both economic output and inflation. In this scenario government bonds tend to do well (even when their yields start at levels much lower than today’s). Within equity markets, consumer staples, utility companies and other defensive businesses do better than the cyclical ones (those that depend on the vicissitudes of the economic cycle).
However, if plunging consumer demand still doesn’t curtail inflation, then bonds are unlikely to increase in value, and it may not be as simple as defensive companies outperforming cyclical ones. Commodities and so-called ‘real’ assets, such as infrastructure, whose incomes tend to rise with inflation, may provide the diversification you would ordinarily get from bonds. And the distinction between defensiveness and cyclicality may matter far less than companies’ ability to push through price increases without affecting demand or than having valuations that move inversely to bond yields.