22 Jun 2022
Central banks are moving from tough talk to action to bring inflation under control. With history showing that policymakers rarely succeed in raising rates without triggering a downturn, Steve Ellis, Global CIO Fixed Income, believes investors should consider adding duration to portfolios as recession risks grow.
This year has been a difficult environment for risk assets, but it’s important not to automatically extrapolate the current environment into the future. Economic conditions can and do change, and we may see both growth and monetary policy shift sooner than the market expects.
Central banks rarely succeed in tightening monetary policy without triggering an economic downturn. At present, markets expect lofty increases of 150-250 basis points in benchmark interest rates in the US, Europe, and the UK over the coming 12 months.
The major central banks have talked tough on inflation in recent months having been too casual in their response last year. To ensure their credibility and bring inflation under control they are under considerable pressure to follow through, and this could spell further sell offs in equities and widening of credit spreads. The latest upsizing of the Fed’s hike to 75bp (first time since 1994) is an important development on this front.
However, the stress on the economy could be greater than many think. Financial conditions are tightening rapidly, and liquidity is draining out of the system, and this is just as Fed quantitative tightening is starting. There’s a real possibility that the major central banks will have to abandon their tightening trajectories prematurely given the fiscal cliff, powerful base effects, a significant loosening of the labour market, swing down in housing market and thawing supply chain issues. If that’s the case, the narrative in the market could shift abruptly and wrong foot investors.
The risk of further asset price dislocation is skewed to the downside and credit markets are still under-pricing corporate defaults that would quickly rise in a recessionary environment. For example, the one-year implied default risk for USD high yield is approximately 2.5% - this seems far too optimistic in a rising rate and slowing growth backdrop. As recession risks grow, we’re likely to see duration perform well and it could make sense to gradually increase exposure to US Treasuries as we think that growth concerns will start to dominate inflation concerns as hard data turns.
Capital preservation in a climate of heightened uncertainty is essential, however, when monetary policy and the market narrative change eventually, there could be exceptional returns available. The ECB put being activated to back-stop periphery spreads show how quickly such a change can happen.
This information is for investment professionals only and should not be relied upon by private investors. Past performance is not a reliable indicator of future returns. Investors should note that the views expressed may no longer be current and may have already been acted upon. Changes in currency exchange rates may affect the value of investments in overseas markets. The value of bonds is influenced by movements in interest rates and bond yields. If interest rates and so bond yields rise, bond prices tend to fall, and vice versa. The price of bonds with a longer lifetime until maturity is generally more sensitive to interest rate movements than those with a shorter lifetime to maturity. The risk of default is based on the issuers ability to make interest payments and to repay the loan at maturity. Default risk may therefore vary between government issuers as well as between different corporate issuers. Due to the greater possibility of default, an investment in a corporate bond is generally less secure than an investment in government bonds. Reference in this document to specific securities should not be interpreted as a recommendation to buy or sell these securities and is only included for illustration purposes.