· Treasury bonds gain favour from investors as growth concerns rise
· The 60:40 portfolio had one of the worst quarters on record
· Adjusting our exposure to anticipate a higher inflation and interest rate environment
After a difficult month of April, risk assets have rebounded strongly in late May to finish the month on a mildly positive note. The recent turnaround in global equities and credit spreads came as yields on sovereign bonds began to move lower this month. After more than a year of relentless selling in bonds across the curve, investor demand for fixed income has started to rise.
With fears of a global recession on the horizon, bond investors have lowered their expectations for the policy rate at which the Fed will end their tightening cycle. The Fed has indicated that they intend to tighten financial conditions considerably to combat inflation - which has remained at a muti-decade high rate for much longer than expected. The halt in the march upward in yields has come as a welcome relief to equity and credit markets.
Central banks have been piling on the hawkish rhetoric in an effort to prevent a wage-price spiral, where higher wages become entrenched - leading to companies being forced to raise prices to maintain their margins. But they risk being behind the curve once more, tightening conditions too far in the face of already slowing economic growth. Thus far, the Fed’s messaging has proved effective at anchoring inflation expectations. Indeed, market implied 10-year inflation expectations stand at around 2.6%
In Europe, the deterioration of the growth outlook is more advanced than in the US. The effects of the war in Ukraine and higher energy prices are more pronounced. The consumer sector has taken a hit, with real incomes severely impacted by higher prices. Industrial production and economic sentiment indices have slowed dramatically as the economy stutters.
In the US, economic data shows fewer signs of an imminent recession, but market internals are pricing in a very high probability of a sustained growth slowdown. Early signs of lower demand in the housing sector, driven by lower disposable incomes and higher mortgage rates, could signal trouble ahead. Purchasing managers are also reporting slower new orders and a build of inventories, usually indicative of slowing demand. Inflation adjusted retail sales also indicate that cracks are starting to form in the US consumer sector.
Negative spill over effects from the shutdowns in China add further uncertainty to the outlook, with slower data out of China usually leading western economies by a quarter or two.
Taking the growth outlook into account, central banks will attempt to anticipate early signs of decreasing inflation in order to orchestrate a ‘soft landing’, while still retaining credibility. Shelter costs, the largest component of the CPI, are still increasing. These tend to lag the other subcomponents by some time and are usually as a result of earlier price increases in the cycle. Price pressures are broadening to some of the stickier components of the basket, notably in services.
There have been few places hide in 2022. The traditional 60:40 equity/bond portfolio has had one of the worst quarters on record. The negative correlation between these two asset classes, usually so helpful for portfolio diversification, reversed this year. Investors would have done well to load up on commodities, notably energy. Global macro and commodity-based hedge funds have also fared well.
Global Economic Data Highlights
As previously noted, we anticipate growth to continue to slow this year in the US and Europe. Driven by lower real incomes and higher private lending rates, consumer demand and the housing sector will weaken considerably. Corporate margins will deteriorate as higher labour and input costs, as well as lower demand, are realised. Analyst earnings expectations are very strong considering this outlook, leaving equities vulnerable to negative surprises in the quarters ahead. Inflation may have already peaked from a year-on-year perspective but will remain stickier than expected month-on-month due to higher priced service sub-components - such as shelter. Longer-term, we expect to enter a period of higher base inflation and nominal bond yields. We are positioning our portfolio to take this new expected environment into account.
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