IHYF - Q2 2023 Global Outlook Update: New Investment Playbook In Action

2023-03-31 03:30:00 ET

Summary

• Pricing the damage: Financial cracks and economic damage are emerging from the fastest rate hiking cycle since the 1980s. What matters: how much damage is in the price and our assessment of market risk sentiment.
• Rethinking bonds: We see higher yields, especially in short-term government paper, as a gift to investors after years of being starved of income.
• Living with inflation: Central banks are likely to stop their rapid rate hikes when the economic and financial damage becomes clearer, with inflation likely settling above 2% policy targets.

Volatile regime in motion

Over the past 18 months or so, we have been flagging that the new regime of higher macroeconomic and market volatility is playing out and that a new investment playbook is necessary.

In this regime, central banks face a sharper trade-off than they have experienced in the past four decades, between crushing growth or living with higher inflation.

Central banks are deliberately causing recessions by hiking interest rates to try to rein in inflation. We see the banking tumult as a manifestation of the damage and financial cracks that we’ve said would appear from such rapid rate hikes.

More damage is emerging

Across a swath of different measures, we are seeing economic damage emerge. These include housing, industrial and consumer indicators. Credit conditions were already tightening before the bank turmoil, and we expect them to tighten further. Yet we don’t see a repeat of the 2008 financial crisis but instead this all reinforces our recession view.

Central banks have also made clear in recent weeks that curbing inflation is not at odds with acting to contain the fallout of the bank tumult. Yet markets have been quick to price in sharp rate cuts. That’s the old playbook.

A sharper growth-inflation trade-off

Source: BlackRock Investment Institute, Federal Reserve, March 2023. Notes: The chart shows the progression of the median Federal Open Market Committee projection for Q4 2023 U.S. real GDP growth and core PCE inflation year-over-year, from September 2021 to March 2023.

The chart above shows that the Fed is waking up to this sharper trade-off. The Fed has been repeatedly too optimistic on both growth and inflation. Its latest projections imply a recession in the months ahead, with growth stalling later in 2023 after a strong start to the year.

The Fed still doesn’t plan to cut rates because inflation is persistently above its 2% target. So it is expecting to live with lingering inflation above its target through 2025, even with recession. We don’t expect central banks to come to the rescue with rate cuts this year.

Labor shortages = higher inflation

Even so, we think the Fed is underestimating how stubborn inflation is proving due to a tight labor market. In the U.S., this is primarily due to a labor shortage as more people reach retirement age and many retire early. Employers are having to raise wages to attract workers.

Europe faces a similar challenge, but the cause of their labor shortage is different. The public sector has grown tremendously during the pandemic leaving a smaller pool of workers in the private sector.

A tight labor market is not likely to ease by itself anytime soon. That means inflation could remain above central bank targets for even longer than they expect.

We estimate that inflation will settle above pre-pandemic levels and the 2% targets of central banks.

What does this mean for investing?

Developed market equities are not pricing in the damage to come. That’s clear in corporate earnings expectations. Cost pressures due to elevated inflation are likely to crimp profit margins.

We like very short-term government paper for income and inflation-linked bonds. We also like emerging market assets that can better withstand the troubles in major economies. We have downgraded investment grade credit to neutral and higher yield to underweight as we see the banking tumult leading to tighter credit conditions.

Yield is back

Market expectations for rate cuts this year seems overdone to us. Two-year Treasuries could take a hit as any repricing happens. That’s why we prefer inflation-linked bonds and very short-term government paper for income. Treasury bills with maturities of a year or under are more attractive for their income and lack of interest rate risk.

This post originally appeared on the iShares Market Insights.

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