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Higher interest rates spark higher volatility and a safety-first approach
Stocks and bonds prefer falling central bank interest rates to today’s rising rates
Our investment starting point is tricky: a high inflation environment that eats away at the purchasing power of households, and potentially at company profitability.
This backdrop of uncomfortably soaring inflation has not been seen in decades, not since the 1970-1980s. Furthermore, this scenario of fast-rising prices results in a combination of a) higher short- and long-term interest rates, and b) slowing economic growth late in the business cycle.
This twin drag on economic growth of a) an effective inflation “tax” on consumers and companies, together with b) more expensive financing costs for mortgages and loans, is not an ideal cocktail for investors in the traditional asset classes of stocks, bonds, cash and property.
A historical analysis reveals that at times of higher inflation and rising interest rates, commodities including gold and oil tend to perform better, while bonds in particular struggle.
Q1 2022 proved difficult for stocks and bonds, while commodities shone
Global stock and bonds markets were finally starting to emerge from the COVID-19 health crisis, only to undergo a second crisis, namely the conflict in Ukraine, making it a difficult first quarter. The MSCI World index lost 5% in US dollar terms over Q1 2022, with no offset from global bonds or global listed real estate, which shed 6% and 4% respectively over the same period. This is a historically rare occurrence. 1994 was the last time stocks, bonds and listed real estate fell together. Commodities (including base metals, precious metals and energy) have proved a useful diversifying asset class at this time of falls in stock and bond prices, with the Bloomberg commodities index ex. agriculture up 31% over 2022 to date.
We have to plan for the current uncertain geopolitical climate persisting for some time to come. This suggests that financial markets will equally remain volatile for the foreseeable future. Markets do not like uncertainty.
Key themes: strategic assets, inflation hedging, the circular economy
The global economy today is struggling to cope with two sets of economic shocks. The first is the damage done to global supply chains by repeated waves of COVID-related lockdowns across the world. Second, the disruption to the supply of key energy, foodstuffs and industrial metals resulting from the Ukraine conflict and related economic sanctions on Russia. Our first investment theme addressing Strategic Assets highlights the pressing need for countries to secure reliable supplies of energy, food, raw materials and key technologies and components from stable and predictable jurisdictions.
Building diversified inflation-hedging exposure via real assets such as commodities, infrastructure and real estate and other inflation-proofing assets remains a key priority in this period of high inflation volatility.
Fragile global logistics networks and ever-more expensive raw material costs represent a huge economic incentive to the circular economy model. Indeed, this model prioritises the optimisation of natural resource use via better and more modular design, better availability of spare parts for repair, ways to reuse or even upcycle, sell items second-hand and recycle goods at the end of life to recover key raw materials.
Economic Outlook and Interest Rates
Weaker growth but no recession
Recent business survey readings, particularly of consumer sentiment, have highlighted the impact of military conflict in Ukraine. There are, however, significant differences between countries. The eurozone is most exposed due to its high share of energy imports. Underlying fundamentals still remain solid. Job creation is very strong in most Western economies and this should support income. Public spending should expand to finance an acceleration in the energy transition towards a low-carbon economy, a priority as countries have now realised the need to reduce their dependence on Russian supply. Finally, new risks of supply chain bottlenecks should prompt companies to invest to relocalise production and to rebuild inventories. We expect Gross Domestic Product (GDP) growth in 2022 of 2.8% in the eurozone and 3.7% in the US. For 2023, the figures are 2.7% and 2.5% for the respective regions.
Inflation will stay higher for longer
The military conflict in Ukraine has fuelled increased uncertainty around inflation. Consumer price year-on-year comparisons have soared to new highs. Unsurprisingly then, inflation remains the key source of uncertainty for investors. We expect inflation to peak in the coming months, but the speed of normalisation remains unpredictable. This is mainly due to sustained high energy prices and supply-chain bottlenecks. Inflation will remain higher than pre-COVID levels due to the transition towards renewable energies and energy security. Food price inflation could also hamper the normalisation process especially in emerging economies. In our base-case scenario, we forecast eurozone inflation to reach 6.7% and 3.2% for this and next year. For the US, we expect 7.5% and 3.4%.
The path towards higher interest rates
High and broad-based inflation is putting more pressure on central banks, the US in focus. The US Federal Reserve intends to hike rates faster and harder in this rate-hike cycle to tighten financial conditions. We forecast five additional rate increases this year, starting with a 50bps rate hike in May. We thus expect the Fed Funds rate to end 2022 at 2.0%. As the Fed favours raising rates quickly, at the start of the interest rate cycle, we now anticipate the Fed to raise rates just an additional 75bps for next year, leaving our end-2023 Fed funds target at 2.75%. The Fed should announce a programme of balance sheet reduction, starting in May rather than July.
At its March meeting, the European Central Bank (ECB) announced the end of the Pandemic Emergency Purchase Programme (PEPP) and a faster Asset Purchase Programme (APP) tapering (i.e. fewer bond purchases), despite the Russia-Ukraine conflict and the impact on energy prices and European Union growth. This comforts our assumption of a) the ECB ending its net bond purchases of the APP in Q3, and b) a hike in the deposit rate in December by 25bps as it sees proof that inflation is translating into higher wages. We expect rates to be lifted three more times in 2023, bringing the deposit rate to 0.50% and the main refinancing rate to 0.75% by end-2023. General consensus is for interest rate increases across the Group of Ten (G10) economies except in Switzerland and Japan. In emerging economies, central banks started to raise rates in 2021 and should continue in order to curb soaring inflation. The exception is China which is set to continue to lower rates in a bid to strengthen demand.
Edmund Shing, Global Chief Investment Officer (PhD)