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Fixed income investors just experienced a “once-in-a-career” market correction: a 10% decline in the Bloomberg Barclays US Aggregate Bond Index (the “Agg”) through the first four months of 2022. For most allocators, this sharp downturn came in tandem with a painful equity market sell-off that has produced a -15% return for the S&P 500 Index year-to-date. It’s been rough sledding for traditional assets so far this year.
The forces behind the fixed income correction are by now familiar to market participants: rising interest rates, triggered largely by higher and stickier inflation than expected, and a scramble by the US Federal Reserve (Fed) to play “catch up” — in other words, to rein in inflation before a vicious cycle of surging wages and even higher prices takes hold. What now? I’m still hesitant to call a “top” for how high 10-year US rates might climb (beyond 3%) because the trajectory of future inflation remains highly uncertain, but I see tentative signs that we may be nearing a plateau. Below are four considerations that have me leaning…
After years of near deflation across much of Europe, the region is now witnessing persistent price increases. Second-order effects of recent geopolitical developments, particularly the ongoing war in Ukraine, are intensifying the current inflationary environment. This apparent shift to a higher inflation regime, with the resulting expectation of tighter monetary policy and rising interest rates, presents a material challenge for European fixed income investors, raising questions such as:
How best to answer these questions depends on the specific circumstances of each investor, but over the coming months, we aim to share some pointers to help European investors think through the implications of higher inflation for their fixed income portfolios. As a first step, let’s take a closer look at…
An inverted US Treasury yield curve is often viewed as a reliable recession indicator, so the significant flattening of the curve over the past few months — and in an environment of persistent inflationary pressures, to boot — has some economic prognosticators calling for an impending US recession. I say not so fast.
While I acknowledge that the economic outlook will likely deteriorate at the margin as monetary policy tightens, particularly if energy prices remain elevated, I do not believe the recent flattening of the yield curve portends a US recession in the near term. US consumer balance sheets look very healthy, household savings rates are robust, and rising worker wages may help cushion against the impact of higher goods and energy prices. Furthermore, the US should remain relatively shielded from today’s uncertain geopolitical landscape, given its lower oil imports from Russia and its greater…
Now that the Federal Reserve has moved into tightening mode, it’s worth asking when the US deficits and overall debt could become a source of worry. As long as interest rates stay reasonably low without driving persistently high inflation, I believe deficits and the debt won’t matter too much to the economy or markets. The debt won’t be painful to finance and can continue to grow — within reason. In fact, if economic growth is higher than the interest rate on government borrowing, it’s possible for debt to GDP to shrink even amid sizeable deficits.
If rates move up dramatically, however, the cost of financing the debt will go up and pressure the deficit, as higher debt servicing costs will either crowd out other government spending (unlikely) or increase the deficit further (compounding the problem).
For this reason, I think the Fed will be cautious in its tightening approach, with an eye on the “terminal value” of rate hikes. It can steer short rates directly, but shorter-term Treasury bills constitute a little less than 20% of the debt. To influence longer-term rates, it can…
As widely expected, the Federal Open Market Committee (FOMC) yesterday raised its target federal funds rate (for the first time since 2018!) by 25 basis points (bps) and hinted that it will likely begin to reduce the size of its balance sheet “at a coming [Fed] meeting.”
Clearly, the recent tightening of global financial conditions since Russia’s invasion of Ukraine has not yet deterred the Federal Reserve (Fed) from sticking to its well-telegraphed intention to gradually remove monetary policy accommodation in response to persistent US inflationary pressures. The Fed also boosted its inflation forecasts, lowered its economic growth forecast, and now projects seven total rate hikes this year (up from three projected hikes as of January).
I expect the Fed to more or less “look through” the recent volatility of commodity prices (especially oil), unless…
Every quarter for the past six years, the Wisdom of Wellington team has surveyed around 100 of our Wellington colleagues across different investment disciplines and locations to get their views on what we see as the key macro questions of the day. The results can pinpoint where the firm’s views differ from the consensus and can also reveal significant shifts in our collective thinking.
At the start of each year, we ask our colleagues which risks they think the market is most complacent about. This can help us to identify areas where the markets are mispricing risk and thus creating opportunities.
The latest survey reveals that the top underappreciated risks for 2022 were China and oil prices over US$100 a barrel, followed by…
We believe 2022 will be the year when macroeconomic and political developments challenge two deep-rooted misperceptions about the euro area:
The notion that the euro area is a region of inherently low inflation really took hold after the global financial crisis and was reinforced during the European sovereign debt crisis. In stark contrast to then, monetary policy is currently exceptionally loose, while plans to rein in the pandemic-related fiscal stimulus are far more moderate. At the same time, there is significant pent-up consumer demand, and the industrial cycle should…
The emerging markets (EM) local debt sector (as measured by the JP Morgan Government Bond Index – Emerging Markets Global Diversified) just posted its worst calendar-year performance since 2013, returning -8.75% against the headwind of higher EM local interest rates. The underlying culprit? EM inflation surprised to the upside in 2021, forcing a number of EM central banks to raise their policy interest rates in an effort to curb the impact.
Although overall EM inflation did not look materially different from that of the developed world last year, the policy response as of this writing has been starkly different: EM central banks as a group have hiked policy rates aggressively, whereas the US Federal Reserve (Fed) and other developed market counterparts have…
The 1970s were a memorable time for music, but many consumers and investors alike (at least those old enough to remember) might just as soon forget the economic “stagflation” — that toxic combination of flagging growth and soaring inflation — that plagued much of the decade. Forty-some years later, the specter of stagflation has resurfaced, as COVID-related supply-chain disruptions have persisted longer than expected and have converged with expansionary government policy (both monetary and fiscal) to push global inflation meaningfully higher in recent months.
As of this writing, the core Consumer Price Index (CPI) had reached levels well above its 20-year average range, even as GDP growth and many other leading economic indicators had weakened. Rising wages and energy prices have poured fuel on the fire, helping to create those unwelcome echoes of the 1970s — which, not surprisingly, were marked by generally poor real investment returns for…
As foreshadowed by US Federal Reserve (Fed) Chair Jerome Powell in his recent congressional testimony, as well as by other Fed officials, the Federal Open Market Committee (FOMC) yesterday accelerated the timeline for tapering its large-scale asset purchase program. The Fed’s monthly purchases of US Treasuries and agency mortgage-backed securities (MBS) will decline at a faster pace over the next few months, before coming to an end in March 2022. The culprit: rising inflation.
US inflation has been running persistently higher than both the Fed’s forecasts and its target range and has shown signs of broadening out across more goods and services. In response, the FOMC increased its inflation forecasts while also decreasing its growth outlook, as labor shortages and supply-chain bottlenecks have created greater inflationary pressures than the FOMC previously anticipated. The mounting inflationary risks also led the median FOMC participant to now expect the FOMC to hike interest rates three times in 2022 and three times in 2023. The US Treasury yield curve flattened following the release of the FOMC’s revised summary of economic projections, as the front end of the curve moved higher.
While not an imminent risk, market participants will eventually turn their attention to the timing of the Fed’s upcoming…
Investor enthusiasm for Japanese equities has long been dampened by the downward trend in the market during the 1990s and 2000s, as well as by structural challenges ranging from deflation to weak corporate governance. But we think this is an opportune time to consider a Japanese equity allocation, as we see seven potential positives that seem underappreciated by the market:
As discussed in my recently published 2022 Fixed Income Outlook, co-authored by my colleague Jitu Naidu, we believe inflation and interest-rate risks look poised to supplant the global COVID-19 pandemic as the new “bogeymen” facing investors in 2022. The dual specter of persistently higher inflation and steadily rising rates has many allocators particularly worried about potential implications for their fixed income exposures. Accordingly, many are now seeking defensive portfolio strategies — so-called “hedges” — for the new year.
Market pricing for longer-term US inflation was recently in the mid-2% range, based on the latest “breakeven” inflation rates. There are still ongoing debates as to likely inflation outcomes going forward, but most of the informed forecasts appear to…
Every quarter, the Wisdom of Wellington team surveys around 100 of our Wellington colleagues across different investment disciplines and locations to get their views on what we see as the key macro questions of the day. The results can pinpoint where the firm’s views differ from the consensus and can also reveal important shifts in our collective thinking.
The latest survey shows that, while the risk of a US recession is still considered low by historical standards, the probability of stagflation has increased. In our previous survey, 50% of participants noted the risk of a significant upside surprise in US inflation, but that figure has now risen to 63% (Figure 1).
At the same time, our respondents thought the economic cycle was…
The US Federal Reserve’s (Fed’s) message on inflation has changed. Fed Chair Jerome Powell recently characterized supply shocks, bottlenecks, and disruptions as “frustrating” and as “holding up inflation longer than we had thought.” The Fed’s mea culpa is small consolation for investors whose portfolios have not been positioned optimally for a longer-than-expected period of higher inflation.
The question now is: Has inflation already peaked? The short answer is no, in my opinion.
Inflation is being pushed higher by three catalysts — labor, raw materials, and transportation — that are interrelated in ways that…
Today’s record gas prices in Europe and Asia come with wide-ranging ramifications that investors need to be aware of.
Natural gas has been cheap for so long that investors and policymakers may have underestimated its pivotal role in modern-day economies. Now a combination of factors is driving steep increases in European and Asian power prices with the real possibility of shortages. Looking beyond the immediate repercussions we see significant investment implications.
In the short run, high power prices could mean:
With a sustained rise in interest rates in the coming months a distinct possibility as of this writing, we thought now would be an opportune time to take a close look at some potential impacts of higher rates on clients’ fixed income portfolios. To do so, we compared the hypothetical five-year performance of the Bloomberg US Aggregate Bond Index under three different illustrative scenarios that could play out going forward: 1) rates remain unchanged; 2) rates rise abruptly; and 3) rates rise gradually (i.e., over three years).
A few of our main takeaways from this analysis were as follows:
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