The global scene: where do we stand? 

When the global supply curve shifts to the left and demand shifts to the right (basically the emergence from COVID plus the war scenario), then prices rise. It happens in aggregate and it happens at the micro level because supply is disrupted everywhere meaning shortages of inputs to which the rational market response is to allocate through the price mechanism.

Reversing this means moving the supply curve back to the right (end of war, increased output in key sectors, workers returning post-COVID – all of which central banks can’t affect) and moving the demand curve to the left (raising the cost of credit – which central banks can affect). That is basically the policy road we are on with there being a good deal of hopes and prayers that a soft landing can be achieved.

In the 1970s and 1980s, recessions did start before the Fed had finished tightening but that was when inflation and rates were much higher and economies less flexible and global. Since the 1980s, the dating of the beginning of recessions has tended to come sometime after the last hike. At the time, policy makers thought they had delivered a soft landing but in time a recession was declared, starting anywhere from 6 to 17 months later. Because there is no visibility on a recession as yet, earnings forecasts are not factoring that in. Hence equities have actually performed reasonably well since the Fed hiked rates on March 18th. (Historically, equity prices fall more when the recession starts, and the Fed is cutting rather than ahead of the rate hiking cycle and the recession). 

If inflation is the dominant macro factor, bonds should be experiencing significantly normalized underperformance. The correction in the S&P500 relative to its historical volatility is not unusual relative to that seen in bonds. Bond yields could still go higher but, again, the worst might have been seen in terms of losses. If the narrative does turn to recession, the tables might turn and multi-asset investors will benefit from higher bond yields providing a more effective hedge against equity returns than has been the case in the last year or so.

I’m not saying markets are a “buy” right now. There remains so much uncertainty in the outlook that higher risk premiums are warranted everywhere. But we have had meaningful valuation adjustments and corresponding losses. For bonds the losses have been historically large. The way fixed income works is that for every further 10bps that yields rise from current levels, the total return hit will be less than it was when yields bottomed in August of last year. Higher carry and convexity make sure of that.

In the short term, inflation is going to remain high and that will support inflation-linked bond performance. There is more upside to interest rates and that means floating rate debt instruments offer an element of defensiveness with many also providing decent cash-flow because of their credit profile. For riskier factors – duration, credit, equity – it is not clear yet. We are moving towards buying opportunities – even if for shorter-term periods. Or even for longer. Low price and high coupon bonds, better quality short-duration high yield bonds, equities with earnings growth and low levels of debt. These are the investment opportunities for now in a market that has universally delivered more “value” than seen for some time.