The end of free money hurts
Markets are tricky to navigate these days, to say the least. Both bonds and equities experienced record-breaking worst first trimesters, and even the niches where investors could shield themselves just a few weeks ago, namely commodities and energy companies, have not been of great help of late. The financial world is in the midst of a painful and unfamiliar transition. After a decade of ultra-low interest rates and what seemed like “quantitative easing (QE) forever”, we are finally seeing a credible tightening cycle from the US Federal Reserve. It is the beginning of the end of the “free money” era.
What separates this attempt to end financial repression from others in the past is that we are operating in a “post-invasion of Ukraine” world. The Russian invasion has sent shockwaves throughout the West, shining a light on its inconvenient dependence on countries that may not always be reliable partners. Going forward, Western governments will work to onshore their energy, technology, manufacturing, and defence supply chains, accelerating the reversal in globalisation. This, in turn, for the first time since the Global Financial Crisis (GFC), has the potential to revive domestic investment and jump-start private credit demand.
This means that, paradoxically, a policy mistake is much less likely today than before Feb 24, and the Fed indeed has more room to tighten. We are, however, not as bold as the current consensus with our expectations of rate hikes. Crucially, both the US and Europe face real-world capability constraints to onshore production. The acquisition of new expertise and know-how in sectors that have sometimes been neglected or abandoned (e.g. semiconductors or nuclear energy) is not an overnight affair, and the switch from foreign to domestic suppliers will take time. Ultimately, the transition timeline does not allow for a full return of high interest rates this time around, but the prospect is definitely in the cards for future cycles.
US nominal growth is high
Against the background of strong consumer demand and impressive investment spending, the Fed raised the key interest rate by 50 basis points (bps) at its meeting on May 4, the most in more than 20 years. Indeed, spending on new equipment grew by an impressive 15% in real and annualised
terms in the first quarter, testimony of a strong corporate sector. Although the US purchasing managers’ indices for the manufacturing and service sectors were somewhat lower in April than in the previous month, not least in anticipation of sharply rising key interest rates, they are clearly in expansionary territory, which suggests that a recession in the US is rather unlikely for the time being.
The Fed may be concerned that domestic demand continues to exceed the domestic supply of goods and services, as evidenced by rising net imports in the first quarter and the fact that there are still nearly two job openings for every American jobseeker. It is therefore not surprising that the recent rise in US house prices seems to be due to rising construction costs rather than underlying asset inflation. Given the negative impact of inflation on low-income household consumption and lower asset prices on high-income household spending, the Fed has to perform a balancing act in the months ahead.
Worst bond market rout ever
Global bond markets continued their correction on an unprecedented scale. Since peaking last year, before central banks started to reduce their monetary accommodation, the broad Bloomberg Global Aggregate Bond Index lost more than 12% on a total-return basis. The Global Government Bond Index fared even worse, losing 19%, more than the Global High Yield Index, which has fallen 14%.
To put these numbers into perspective, when the Fed raised interest rates in 2018 (which, in hindsight, was too bold a move), the indices lost between 3% and 5%. And in 1994, when Fed Chair Greenspan doubled the policy rate from 3% to 6%, there was only a one-year period of flat returns.
A confluence of factors has led to this truly once-in-a-lifetime collapse of bond markets. First among these is the radical shift in policy mix. For several years, we have observed the narrative of fiscal austerity at all costs, and this has formed the basis of the weak
productivity growth and rising populism we see now. Central bankers have tried their best to limit the damage using ultra-easy monetary policy.
We have written extensively about the one positive aspect of the Covid-19 crisis, namely the transition to a proactive, pro-growth fiscal policy. All major central banks, with the exception of the Bank of Japan, have concluded that monetary policy support is no longer needed and have even moved to a tightening stance much faster than the market had expected and even faster than we believe the fundamentals warrant. The surge in energy — and ultimately consumer — prices has certainly pushed central bankers into this direction. Six months ago, the Fed indicated its intention to deliver one 25bps rate hike in 2022. So far, we have already witnessed two hikes totalling 75bps and a pledge from Fed Chair Powell to deliver many more.
Fortunately, we can say that past performance is no guidance for future performance. A rapid return to a more neutral level of interest rates is priced in, and credit spreads have widened above their long-term averages. The return outlook for fixed income instruments has not been brighter for years, as short- and medium-term investment-grade bonds are delivering a 4% yield or more. With inflation correcting lower over time, this is an attractive entry point that we will seek to exploit in our portfolios.
Equities do not price in a recession
Despite the apparent doom and gloom on the markets, just as US macroeconomic readings remain robust, equities are not pricing in a recession. The S&P 500 touched a key level this week, dipping below the 4,000-mark, which was last visited on the way up in March 2021, just as global liquidity growth was peaking. To price in an economic downturn, earnings would have to decline by 20% or more, which would put the flagship index in the lower 3,000s, or at least another leg down of 15%.
Importantly, the US and European private sectors do not show any sign of endogenous imbalances, such as those seen in 2001 (excessive capital expenditures in the Internet sector) or 2008 (excessive housing sector investment). Moreover, inflation should start to roll over as the commodity supply-chain bottleneck effects from the pandemic and the war in Ukraine start to fade. Julius Baer Research does not expect a commodity super cycle, and there is no general physical shortage of commodities.
Therefore, recession is not our basecase scenario. Nevertheless, if we do get there, as nominal growth peaks, growth and quality stocks should outperform. Keeping that in mind and acknowledging the almost unprecedented uncertainty we are facing, investors should aim for a balanced portfolio in terms of equity styles.
Looking at the long-term big picture, we see 2022 as the year of the “Great Reset”, the true transition point to the new era of monetary and fiscal policy, and deglobalisation. This is the right time to start preparing portfolios for the new reflationary regime.
There are three key elements to keep in mind. First, investors should reconsider their geographical allocation, as financial markets are no longer immune to geopolitical affairs; the risk of capital confiscation has risen significantly since the start of the war in Ukraine. Second, even more emphasis in the portfolio should be put on the allocation to real assets, including private and public equities, as these historically outperform in sustained inflation periods. Third, it is time to steer funds to those companies that should adapt well and profit from the onshoring trend — which includes previously shunned commodity and energy producers.