Markets held up well in the face of rising rates, escalating geopolitical tensions and further shutdowns in China. The strength of the US economy is the main reason for this, with an acceleration of 6.9% annualized in the fourth quarter. Although growth is strong, the question remains: how sustainable is it and is a recession likely in the short term?

To know where we are going, we need to look at where growth is coming from, especially as we move out of global lockdowns. The answer lies in the record stimulus used to offset the impacts of the pandemic. With the lifting of lockdowns, we are left with the consequences of rising money supply during a time of supply chain issues; the result of more money chasing fewer goods led to the inflation we see today. That can become a problem if the growth impetus from the stimulus fades as inflation remains sticky, largely due to China’s new shutdowns crippling supply chains.

The way central banks fight inflation is by raising interest rates to slow demand, which should give suppliers time to replenish stocks. Again, this picture becomes murky if net global exporters are locked in again. What is clear is that central banks around the world are unlikely to back down from their hawkish stance anytime soon, with inflation becoming one of the main concerns of the average consumer.

When growth slowed in the early lockdowns of 2020, central banks turned to the “wealth effect” to encourage spending, easing financial conditions to help boost asset prices. As the value of pension funds increased and the value of homes rose, this encouraged increased spending and consumer confidence. Today, regulators face the opposite dilemma – the economy is too hot and inflation is running high. Central bank rhetoric on aggressive rate hikes is partly aimed at cooling the wealth effect, which should create volatility in asset markets. Today, financial conditions remain loose, which means central banks need to do more to tighten conditions.

Rate hikes were well communicated and bond markets reacted with one of the most aggressive rate cuts in anticipation of a rising rate environment. The question is how much central banks can tighten without collateral damage in other parts of the economy. Since the start of the pandemic, the world has had much higher levels of debt, both in the public and private sectors, so the terminal rate for many parts of the world is lower than it was before the pandemic. This means that central banks cannot raise rates before turning to other methods to tighten financial conditions, such as quantitative tightening or tighter lending regulations to slow credit.

Forward yield curves have now priced in a cycle of rate hikes in Australia and the US. This could push interest rates to 2.6% and 2.8% respectively by the end of 2022, according to Bloomberg. The resulting sell-off in fixed income has seen parts of the yield curve invert, signaling that while we will have rate hikes in the near term, central banks will eventually need to step back to ease policy. on the track. Eurodollar futures suggest that this pivot could occur in late 23 or early 24 to combat a future economic downturn.

Case of bonds

This idea is important for bond investors because it suggests that we are potentially at the height of hawkish central bank policy. Citi analysts note that there is a 70% chance that the market will be valued at the peak of long-term returns. Citi also recently lowered its growth forecast from 3.5% to 1.9% for 2022, citing lower disposable income due to high inflation and the rising cost of credit. Although we need two quarters of negative growth to officially qualify a slowdown as a recession, slowing growth will still impact portfolios, and the pace of the slowdown matters too. As the yield curve inverts and real rates turn positive, we may see calls for a recession grow louder. For now, these calls are premature, but it should be noted that we will hear more on this subject, which will undoubtedly have an impact on investor sentiment. Anticipating a deterioration in future sentiment means that investors could start positioning themselves more defensively today.

For a long time, investors had no alternative to risky assets, such as stocks, because returns were close to zero. Today, this is no longer the case and investors can begin to diversify again across the risk spectrum. Should growth slow or be revised lower, high-quality bonds should offer strong portfolio diversification, with the potential to outperform riskier asset classes while paying positive carry.

Historically, during periods of slowing growth and rising rates, bonds have historically outperformed. If we are at the height of the aggressiveness, that means the market may have to undo some of the bulls already discounted in the bond market. If so, adding high-quality bonds to portfolios could be an attractive proposition to capitalize on the recent selloff in the asset class. Investors should also understand that the pace of quantitative tightening could continue to push yields higher. This is because the Federal Reserve is no longer buying Treasuries as part of its balance sheet liquidation and the demand for Treasuries must now be absorbed by the private sector. However, this demand historically increases during periods of slow growth.

Although it is still too early to announce a recession, growth is clearly starting to slow down. This situation is perpetuated by a higher cost of living and lower disposable income. Unfortunately for markets, central banks will not be able to step in to support markets with easing when inflation is a key issue. This means that even if growth slows, we are unlikely to see a strong central bank pivot on their tightening path, which could create additional risk for equities in the coming quarters. While the rate hikes have been well signaled by the markets, the significant slowdown in growth in the second half of the year with tighter policy is likely to lead to increased risk for equities. In this environment, safe-haven assets, such as treasury bills, act as a good diversifier given the uncorrelated nature to equities during times of risk, while offering a higher yield than term deposit rates.

Peter Moussa is Senior Investment Specialist at City Australia, a sponsor of Firstlinks. Any advice is general advice only. It has been prepared without taking into account your objectives, financial situation or needs. You should also obtain and consider the relevant product disclosure statement and terms and conditions before making any decision regarding a financial product. Investors are advised to obtain independent legal, financial and tax advice before investing. Past performance is not an indicator of future performance.