Michael Strobaek Sun, Jun 19, 2022
Financial markets have been caught in a perfect storm, with this week’s forceful back-to-back central bank rate hikes signalling that we are moving into a new world order in markets.
Both equities and bonds have corrected, which means that investors have had almost no place to hide.
Even well diversified portfolios have taken a hit. Investors should not lose faith, however. In fact, they would be ill advised to exit markets now.
The year 2022 has so far felt like a perfect storm for the economy and financial markets. Changing monetary policy, decades-high inflation as well as the war in Ukraine and supply-chain disruptions, to name but a few, have all taken a toll on investor sentiment. The combination of high inflation and slowing growth in particular is a clear concern. High inflation is bad for bonds and fears of slowing growth and recession are bad for equities.
Since the beginning of the year, global equities (as measured by the MSCI AC World) are down roughly 20%, while global bonds (as measured by the Barclays Global Aggregate Index) have lost about 10%.
Over the past few days, this perfect storm has intensified as more and more central banks decided to normalize their monetary policy even faster than previously anticipated.
Already in May, markets expected a fairly brisk interest rate hiking path. When the US Federal Reserve communicated that they would accommodate a 75 bp hike and the Swiss National Bank surprised with an unexpected 50 bp rate hike on 16 June, market participants were forced to adjust expectations yet again, with negative implications for markets.
Embracing the great transition
In our Investment Outlook 2022, which we called “The great transition,” we forecast a deceleration of growth, higher inflation than before the pandemic, central bank rate hikes, more moderate financial market performance and generally the return of economic boom-and-bust cycles.
Our findings are valid, but the events that we have seen since we published our Investment Outlook, such as the war in Ukraine or the latest Covid-19 outbreak in China, have accelerated these developments. Growth is decelerating faster than anticipated, inflation is stickier, monetary policy is normalized faster and financial market returns so far have not been moderate but outright poor.
A painful reset
There are short and long-term consequences of the accelerated great transition. In the short term, it has become very clear that central banks are now strongly committed to bringing inflation rates down and they are willing to risk an economic slowdown to achieve this goal. They want to move away from supportive monetary conditions toward a more neutral rate level as soon as they can. They are this doing to prevent inflation from becoming an even bigger and stickier problem than it currently is and thus avoid the painful mistakes of the 1970s, when inflation became a very big problem. Thus, what they are doing now is good and right.
This represents nothing less than a reset of the currently still low interest rate level to a new, higher level globally. During this adjustment, financial markets look set to remain volatile as the reset brings with it clear uncertainty and, of course, a much less accommodative monetary policy. Among the questions investors have to ask themselves is how long the rate hiking cycle will go and how deep the economic slowdown will be. Both equity and bond markets look set to exhibit strong moves during the adjustment phase as they reprice expectations time and time again.
The good thing about the accelerated hiking path that central banks are on right now is that it is likely to keep the transition phase short. The reset is going to be painful, but shorter than anticipated.
In the new world order
Investors do need to accept the market turbulence as we are in the midst of the interest rate reset. I believe it would be wrong to leave markets at this stage. Financial markets are forward looking and after the volatility of the last few days and weeks, they are pricing in an aggressive central bank rate hiking path already.
Peak hawkishness, i.e. the peak in expectations repricing, might be close. Once we are there, it is not only possible but likely that we will see a rebound in both equities and bonds. However, this rebound will be very difficult to time. Beyond the immediate volatility, the accelerated great transition means that the painful reset of interest rates will probably be short.
For now, investors should continue to keep diversifying portfolios as broadly as they can, for instance by including alternative investments, which have fared much better this year than stocks and bonds. Staying active, for example by selling volatility into uncertainty spikes like the current one, is also a strategy to generate yield in the current environment. In our House View, we recently closed our long-standing underweight in government bonds as higher yield levels are starting to compensate for elevated uncertainty.
For instance, the yield on emerging market hard currency government bonds now exceeds 8%. In equities, we maintain our overweight despite the current turbulence, reflecting our view that an eventual rebound is likely. We introduced this equity overweight in mid-March and split it between developed and emerging markets (EM).
It is worth mentioning that our EM overweight is expressed through an overweight in Chinese equities, whose positive momentum is accelerating. Since introduction, this overweight is strongly outperforming the global benchmark and up in absolute terms, supporting and further diversifying our portfolios.
It is very easy to throw in the towel when market turbulences and perceived risks reach new peaks. Yet, I firmly believe that the situation is not as bleak as the market currently prices.
One of our fundamental investment principles is that “time in the market beats timing the markets.” This, in my opinion, applies to the here and now.
Michael Strobaek is global chief investment officer at Credit Suisse