By: Stephen Dover
Many of the outcomes emerging in the next year will be driven by the changed global economic outlook. A combination of factors, ranging from pandemic-related supply disruptions to global conflict, impaired the manufacture, distribution, and allocation of many goods and services in product and labor markets. Combined with a burst of economic activity underpinned by economic reopening as well as unprecedented fiscal and monetary stimulus, insufficient supply relative to demand has boosted price and wage inflation, necessitating an aggressive tightening of monetary policies in most major and many smaller economies worldwide.
This has led to five key changes in the conditions underpinning capital markets:
- Flat or inverted yield curves across most government bond markets
- A stronger US dollar
- Elevated price volatility in most asset classes
- Diminishing central bank support for financial markets, including in terms of lower liquidity and higher interest rates
- Elevated commodity prices
Also Read: Why did US stock market rally after hot inflation numbers?
Let’s take a deeper look at the implications of these current conditions and what they might signal for the future performance path of major asset classes, including the potential impact on profitability, risk premiums, and valuations.
Is the yield curve inversion predicting a recession?
Yield curve inversion has followed from the pursuit of tighter monetary policies, now underway in most developed and emerging economies. As central banks hike short-term interest rates, expectations for weaker future growth and lower inflation tend to push short-term interest rates above longer-term yields, producing a downward-sloping, or inverted, yield curve. Given the duration of expected monetary policy tightening, a function of today’s unusually high inflation, there is a risk that yield curves will remain flat or inverted for most of the next 12 months.
Inverted yield curves can have profound impacts on asset returns and portfolio performance. For fixed-income investors, when yields on less price-sensitive notes exceed those on riskier bonds, most will likely shorten the duration of their fixed-income holdings, particularly among government securities. This also creates an expanding opportunity set within shorter-duration high-yield and floating-rate debt. At the same time, because yields on the longer-duration end of the maturity curve have also risen, but not as quickly as at the short end, we believe there are opportunities to increase the quality of fixed-income portfolios and achieve capital appreciation by investing in longer-duration US Treasuries and investment-grade corporate debt.
For equity investors, an inverted yield curve typically leads to a preference for quality, stable earnings and growth styles relative to more cyclical or value baskets of stocks. That is true for several reasons.
First, in relative terms, companies with sound future prospects (e.g., growth or consumer staples stocks) enjoy a relative improvement in the discounting of their profits relative to shorter-duration cyclical stocks.
Second, inverted yield curves typically presage economic slowdowns or even recessions, which creates more profits uncertainty or even scarcity. Therefore, investors tend to flock to stocks whose business models are better able to withstand adverse economic conditions. At the same time, because this is the general market consensus, some value-oriented sectors remain attractive to us based on specifics related to their particular businesses. For example, financials are much better capitalized relative to the period prior to the 2007/2008 global financial crisis but are being valued on recession fears.
US dollar strength—global opportunity?
Rising short-term interest rates due to US Federal Reserve (Fed) tightening have propelled the US dollar higher against most other developed and emerging currencies. Other factors have underpinned US dollar appreciation, including geopolitical uncertainty, high oil prices, and weak economic activity in China and other emerging economies.
There are three key implications for asset returns with a strong US dollar. First, a strong US currency tends to force countries exposed to imports from the United States to hike interest rates to curb inflation pressures. That pressure is particularly pronounced for emerging economies. The resulting combination—rising interest rates and weakening domestic currencies—acted as a drag on local-currency emerging market (EM) debt securities.
Also Read: What is Dollar Index and how it impacts the stock market – Explained
Second, a strong US dollar tends to lower US inflation as it makes imports cheaper, thus creating weaker US economic activity due to reduced production. This reinforces the inversion of yield curves.
Third, a strong US dollar redistributes corporate earnings for larger-capitalization multinational firms. US firms with sizable earnings from overseas have seen those profits dwindle when translated back into a strong US dollar, whereas European, Japanese and EM multinationals are reporting windfall gains on their US dollar earnings when translated back into their weaker national currencies.
What does this mean going forward? From a fixed-income perspective, valuations could reach levels that indicate EM sovereign bonds are becoming more attractive relative to developed market options, particularly in countries that remain ahead of the United States in their interest-rate cycles.
On the equity side, valuations outside the United States may become more attractive on a relative basis. Coupled with earnings expectations that remain elevated in the United States, regions such as Europe may offer opportunities because the issues centered around the war in Ukraine have already been discounted.
Elevated volatility—an opportunity for skillful investment?
Unsurprisingly, when central banks tighten aggressively, price volatility tends to rise across all asset classes. Already underway, that process is likely to endure.
In fixed-income markets, volatility jumps because inflation-fighting central bankers can no longer confidently guide investors about their future policies. “Data dependency” replaces “forward guidance” and given the uncertain linkages between supply and demand fundamentals driving today’s inflation, no central banker can confidently communicate where interest rates will be in three, six, or 12 months. Accordingly, short-term interest rates and bond yields are likely to gyrate more significantly than was the case when central banks were targeting “zero” interest rates.
In addition, fixed-income investors may become more troubled by the shift from “quantitative easing” to “quantitative tightening,” i.e., the reduction and reversal of central bank asset purchases. Against the backdrop of huge increases in government and private sector indebtedness, the removal of central banks as bond buyers will likely continue to increase fixed-income volatility.
Tighter monetary policies increase economic and earnings risk. Fed Chairman Jerome Powell stated that some “pain” may be unavoidable. A more uncertain earnings outlook will increase the volatility of equity prices.
Lastly, a growing divergence of monetary policy—some central banks are tightening aggressively (e.g., the Fed and the Bank of England), others more slowly (e.g., the European Central Bank), or not at all (the Bank of Japan)—will likely drive an interest-rate “wedge” between domestic yields across countries, creating conditions for larger exchange-rate moves. The US dollar’s advance this year is the prime manifestation of how monetary policy divergence also creates greater exchange rate volatility.
This volatility inherently creates more idiosyncratic opportunities and the ability for active managers to add alpha. While it may seem like we are advocating for all sectors, asset classes, and regions, the fundamental message is that the current conditions create a better environment for utilizing skill to achieve excess returns, both from active asset allocation and thoughtful investment selection.
Less supportive central banks—more risk for investors
A commitment to fight inflation implies a reduced willingness to fight other risks such as a recession. That matters to investors, who for at least a quarter century have counted on significant liquidity, low-interest rates, and timely interventions from central banks when markets have significantly weakened. That has made investors more willing to take risks, which is one reason why both stock and bond valuations have soared in recent decades.
Less supportive central banks create more risk. As noted, that is evident in volatility. But the risk is also rising for investors who previously counted on a “Greenspan,” “Bernanke,” “Yellen” or “Powell” put option—a helping hand in terms of lower interest rates and added liquidity if markets tumbled. While the Fed has not completely forsworn its commitment to the proper function of financial markets, the ‘Fed put’ clearly now has a much lower strike price, shifting market risk away from the central bank and back to investors.
For investors concerned about this particular risk, the municipal (muni) bond market may offer a specific opportunity considering that fiscal budgets are in surplus, which has led to upgrades from the rating agencies. We believe taxable equivalent yields are attractive relative to other corners of the fixed-income market, and investors have not yet flocked to the asset class, providing some runway for flows to support positive returns.
Additionally, another opportunity may be in private commercial (and more specifically industrial) real estate, where the fundamental dynamics of e-commerce-related warehouses, in particular, may provide an opportunity for strong returns. Rising construction costs and higher interest rates are likely to reduce the ability to add supply, while continued demand allows any cost increases to be passed through to customers.
Elevated commodity prices
Typically, higher interest rates, a stronger US dollar, and weaker growth would erode commodity prices. That may occur for some commodities, particularly those that are most cyclical, such as industrial metals. But supply-side factors are also important, including the squeeze on global energy, food, and fertilizer prices resulting from Russia’s invasion of Ukraine. Supplies of crude oil and natural gas, globally, remain very tight. Hydrocarbon production is increasing in the United States, but slowly, while few producers in the Organization of the Petroleum Exporting Countries (OPEC) or elsewhere have much spare capacity. In food markets, adverse weather conditions are also wreaking havoc on crop yields. Given these conditions, many commodity prices, particularly for food and energy, are unlikely to recede significantly from current levels based solely on weaker global growth.
This leads to a variety of options across the sub-sectors within the energy space, including mid-stream, downstream and upstream operators. From a fixed-income perspective, investment-grade energy bond valuations are attractive relative to recent history. In addition, a large proportion of energy companies were funded through private credit in times of industry stress, particularly during recent periods of lower energy prices. These are other sources of opportunity for investors, providing capital appreciation, higher income, and lower volatility in exchange for illiquidity.
Summary and conclusion
Inverted yield curves, US dollar strength, higher volatility, less supportive monetary policies, and high commodity prices are a troublesome and challenging cocktail for investors more accustomed to low-interest rates, predictability, central bank “puts” and low energy prices.
Yet despair cannot be the strategy of the investor, least of all the long-term investor. Opportunities exist in all market outcomes, and today’s is no different. In our view, today’s environment favors active investors, who look beyond broad stock or bond market performance to identify potential winners. Reaching up and down the capital structure to find the best candidates within asset allocations and including alternative strategies and asset classes to optimize these allocations is particularly effective today, in our view.
(Author is CFA, Chief Market Strategist, Franklin Templeton Institute)