The sharp rise in global bond yields has weighed heavily on fixed income returns in recent weeks. Bond markets have by now priced in a hawkish policy outlook for the Fed. In particular, we think US investment grade credit has become more attractive, with yields above 4% and spreads around their long-term median. We have reduced our underweight allocation, while increasing the underweight in European government bonds, where yields remain comparatively low. More generally, we’re retaining our moderate risk-on allocation in portfolios. Our most preferred regions tactically remain the US (via equities) and emerging markets/Asia (via equities and credit). 

Looking up
The US Federal Reserve (Fed) is in a hawkish mood, with the result that there are likely to be more rate hikes and higher bonds yields in the near term. When growth weakens and inflation moderates, we expect the central bank to slow the pace of its tightening programme. We also believe US policymakers will avoid making a mistake by increasing rates too aggressively, and we’re more dovish than market expectations for European Central Bank and Bank of England policies.

Geopolitical risks remain, which are dominated by the war in Ukraine and economic sanctions against Russia. Energy and commodities markets are volatile and the high price of many raw materials, as well as the disruption to supply, could keep inflation higher for longer. We’re also watching for any possible economic and market implications from the recent presidential election in France, though we suspect they’ll matter more over the longer term. 

The global economy continues to recover despite risks to the outlook. They include the conflict between Russia and Ukraine, China’s zero Covid approach and strained global supply chains. There’s also the possibility that central banks could make a mistake by hiking interest rates too quickly. Although the euro area could weaken, we believe economic actively will remain resilient, particularly in the US, while forthcoming policy stimulus should provide some relief from lockdowns in China.

At this point in the business cycle, we believe the pace of economic expansion and company earnings growth has already peaked, even though both remain positive. Inflation remains high for a variety of reasons, but may already have peaked too, and is likely to fall as demand normalises, supply expands and government stimulus measures wane. As inflation rose strongly last year, the mathematical comparison with a year ago – comparing this year inflation figures to last year – will also help to push down the annual figures.

The yield on some longer-dated US Treasuries dropped below that on shorter-dated bills recently. An inverted yield curve is often a powerful economic omen of a upcoming recession but our calculations suggest it’s unlikely over the next 12 months. The probability increases over long time horizons and it will inevitably happen at some point. Yet we believe it’s likely to be mild because the US lacks the financial imbalances that are usually associated with a sharp contraction.

A spell of warm weather around Easter time can be deceptive. You’re out in a T-shirt enjoying the sunshine one day and then back in your winter coat the next as the temperature dips back down. In a similar way to how the changing of the seasons doesn’t happen smoothly, economic conditions are often unsettled during a period of transition – like the one taking place now as central banks tighten monetary policy with a series of interest rate rises. 

There are many factors for rate setters to consider, including quite a few uncertainties, such as persistently high inflation, China’s zero Covid stance and global supply chain disruptions. The devastating war in Ukraine and humanitarian crisis is also a stark reminder that the world order can quickly become unbalanced. We’ll be exploring many of these issues and what they mean for financial markets in our mid-year outlook, which will be published in June. 

Central bank policy is the dominant theme for investors at the moment with the frequency and magnitude of interest rate hikes driving the outlook for returns

Hawks and doves 

COUNTERPOINT
MAY 2022