Markets have been resilient in the face of rising rates, escalating geopolitical tensions and fresh lockdowns in China. The strength of the US economy is the key reason, accelerating 6.9% annualized in the fourth quarter. While growth is strong, the question remains: How sustainable is it, and is a recession likely in the near term?
To answer where we are headed, we need to look at where the growth has come from, especially as we emerge from global lockdowns. The answer lies in the record stimulus used to offset pandemic impacts. With lockdowns lifted, we are left with the consequences of increased money supply during a period of supply chain issues; the result of more money chasing fewer goods led to the inflation we see today. This can become a problem if the growth impulse from the stimulus fades while inflation remains sticky, largely due to China’s renewed lockdowns crippling supply chains.
The way central banks combat inflation is by raising interest rates to slow demand, which should give suppliers time to replenish inventories. Again, this picture becomes muddy if net global exporters are back in lockdown. What’s clear is that central banks around the world are unlikely to pivot from their hawkish stance anytime soon as inflation becomes one of the biggest concerns for the average consumer.
When growth slowed during the initial 2020 lockdowns, central banks turned to the ‘wealth effect’ to encourage spending, loosening financial conditions to help boost asset prices. As superannuation fund values rose and home values increased, it encouraged higher spending and consumer confidence. Today, regulators are faced with the opposite dilemma - the economy is too hot, and inflation is rampant. The rhetoric from central banks on aggressive rate hikes is partly intended to cool the wealth effect, which should create volatility across asset markets. Today, financial conditions remain loose, meaning central banks need to do more to tighten conditions.
Rate hikes have been well communicated and bond markets have reacted with one of the most aggressive sell downs in anticipation of a rising rate environment. The question is how hard central banks can tighten without collateral damage in other parts of the economy. Since the start of the pandemic, the world has much higher debt levels, both in the public and private sectors, so the terminal rate for many parts of the world is less than where it was pre-pandemic. This means there is only so much central banks can raise rates before they turn to alternative methods to tighten financial conditions, such as quantitative tightening or stronger lending regulation to slow credit.
Forward rate curves have now priced in a cycle of rate hikes in Australia and the US. This could bring interest rates to 2.6% and 2.8% respectively by the end of 2022, according to Bloomberg. The resulting fixed income sell-off has seen parts of the yield curve invert, signaling that while we will get rate hikes in the near term, central banks will eventually have to pivot back to loosen policy down the track. Eurodollar futures suggest this pivot could happen in late ’23 or early ’24 to combat a future economic slowdown.
Case for bonds
This insight is important for bond investors as it suggests we are potentially at peak central bank hawkishness. Citi analysts note there is a 70% probability the market is priced at the peak of longer-term yields. Citi has also recently downgraded growth forecasts from 3.5% to 1.9% for 2022, citing a decline in disposable incomes due to high inflation and the rising cost of credit. While we need two-quarters of negative growth to officially label a slowdown a recession, slowing growth will still impact portfolios, and the pace of the slowdown also matters. As the yield curve inverts and real rates turn positive, we could see the calls for a recession get louder. For now, those calls are premature, but it is worth noting that we will hear more about this topic, which will no doubt impact investor sentiment. Anticipating a deterioration in future sentiment means investors could start to position more defensively today.
For a long time, investors had no alternative to risky assets, such as equities, because yields were pinned near zero. Today, this is no longer the case, and investors can go back to diversifying across the risk spectrum. Should growth slow or be revised lower, high-quality bonds should offer strong diversification for portfolios, with the potential to outperform riskier asset classes while paying a positive carry.
Historically, during periods of slowing growth and rising rates, bonds have historically outperformed. If we are at peak hawkishness, it means that the market may need to unwind some of the hikes already discounted in the bond market. If this is the case, then adding high-quality bonds to portfolios could be a valuable proposition to take advantage of the recent sell-off in the asset class. Investors should also understand the pace of quantitative tightening could continue to push yields higher. This is due to the Federal Reserve no longer purchasing treasuries as part of its balance sheet run-off and treasury demand now needing to be absorbed by the private sector. However, this demand historically rises during periods of slowing growth.
While it remains too early to call for a recession, growth is clearly starting to slow. This is perpetuated by a higher cost of living and lower disposable incomes. Unfortunately for markets, central banks won’t be able to step in to backstop markets with easing while inflation is a key issue. This means that even as growth slows, we are unlikely to see a strong pivot from central banks on their tightening path which could create added risk in equities for the next few quarters. While the rate hikes have been well flagged by markets, the backdrop of meaningfully slowing growth in the second half of the year with tighter policy is likely to lead to added risk for equities. In this environment, safe-haven assets, such as treasuries, act as a good diversifier given the uncorrelated nature to equities during periods of risk-off, while offering a yield above term deposit rates.
Peter Moussa is a Senior Investment Specialist at Citi Australia, a sponsor of Firstlinks. Any advice is general advice only. It was prepared without taking into account your objectives, financial situation, or needs. You should also obtain and consider the relevant Product Disclosure Statement and terms and conditions before you make a decision about any financial product. Investors are advised to obtain independent legal, financial, and taxation advice prior to investing. Past performance is not an indicator of future performance.