Far seem the days of 2016 and 2017 where financial markets marched to the beat of slow but stable growth, where high volatility was an anomaly rather than the everyday and intraday norm. Even in the more turbulent days of 2018, and amidst the rate-tightening cycle which initiated in December 2016, market participants held strongly and fervently to the notion of the “Fed put”, which provided more stable expectations. The Fed put, a concept which borrows from the terminology of options markets, and analogous to having an insurance policy if prices collapse, is the belief that the Fed will step in and buoy risk assets by providing forward guidance of growth supportive monetary policy. As we trot into the second half of 2022, we believe the fiercely dissimilar financial and economic framework we are in now makes Fed put devotees highly assailable.
With inflation at center front stage for most global monetary policy actors, the FOMC’s reaction function to weakness in financial assets and employment is very different. In the past several cycles, as the equity markets sold off when the economy weakened, the Fed eased rates to guide expectations of economic recovery and to provide a bottom in the risk asset sell-offs. This time, the Fed is constrained by excruciatingly high inflation such that even amid financial and real economic weakness, it will need to maintain tighter monetary policy for a longer period.
As we discussed in our year-end 2021 review, 2022 was foreseen to be difficult for risk assets. Although we understood and internalized the downside risks, we did not anticipate the magnitude of the shock. We ended the year expecting monetary and fiscal policy to tighten as we sat at high valuations in risk assets, relative to their history. We projected the risk of higher-than-anticipated inflation readings and unpriced hawkish moves from the Fed. We were pleased after moving our equity allocation from overweight to neutral in October 2021. As we closed 2021 with a YoY December CPI print of 7% and with FOMC projections of the fed funds rate to increase to 0.9% by 2022-year end, we anticipated that 2022 would operate under a healthy tug of war between less accommodative policy and a global economy benefitting from activity reopening and less supply constraints. The global structure materially changed though on February 24th after the invasion by Russia in Ukrainian territory. The Russia invasion exacerbated existing inflationary pressures by creating strong supply shocks across energy and food markets. The Fed, which continued to see month to month inflation print increases, had to react abruptly by discussing quicker and heftier rate hikes. Increases in real rates across the yield curve led to steep bond price declines and a repricing cascade across risk assets.
In a short period of time, the Fed has shifted from gigantic quantitative easing in response to the COVID-19 shock to hawkish interest rate hikes and quantitative tightening twice as large as that of previous episodes. With liquidity contracting strongly reverberating across global financial assets broadly and interest rates across the globe raising to counter inflation, it is difficult to foresee the drawdown across risk assets to be over.
As much as we are fixated on inflation and the heightened need of Central Banks to tame economic activity, it seems the market has realized that the idea of a soft landing where the Fed is able to decrease inflationary pressures without orchestrating a recession is romanticized. When analyzing the bond markets and the most liquid derivatives of USD risk-free instruments, it is clear to see participants expect a reversal of the Fed’s hawkish interest rate policy as early as next year to combat economic weakness. Widely discussed in the media, the yield curve as measured as the difference between 2y and 10y maturities is inverted by almost 20 bps as of July 18th. The Eurodollar market, important across the world for Central Banks and governments to get exposure to USD, also shows an inversion in the futures curve starting March 2023. This inversion signal is radically important, especially because of how early the market expects a shift in the Fed policy. A lot of Fed tightening is priced into the rates markets, as Fed fund futures show that the market expects the FOMC to hike to 3.25-3.50% corridor by year end. In essence the market is signaling that the demand destruction from rate hikes will be such, that apart from easing inflationary pressures, the Fed will be forced to step in and decrease rates to stimulate growth and prevent further economic weakness. If the above scenario is remotely close to what ends up unfolding in the next 8 months, then we must prepare for a long ride of volatility.
This narrative of an economic environment where inflation drops, and economic weakness becomes center stage for policy makers, is somewhat consistent from the recent price dynamics we have witnessed across other assets. The USD has had a strong rally since November 2021, and apart from a small correction in early June, it has continued to move higher relative to both EM and DM currencies. The USD is a beacon of safe haven and has been a countercyclical asset for multiple decades now. Copper and most industrial metals, including nickel, aluminum, and iron, have decreased steeply in price since the beginning of June, even as goods continue to show positive monthly inflationary pressures and China adds possible further supply constraints as it reconsiders more activity restrictions due to COVID spikes. Equity markets, as forward discounting machines, have fallen close to 20% in the US as the multiple paid on earnings decreased sharply following the hawkish Fed policy move. Although there has been a strong correction in the frothiest areas of the market, including unprofitable growth companies, cryptocurrencies, and other long duration assets, some equity buckets are not pricing the degree of economic weakness that the risk-free markets are signaling.
The global outlook remains extremely fragile and extremely uncertain. The IMF decreased global growth projections in April to 3.6% in 2022, down from 6.1% in 2021, and they have recently announced they will be moving projections even lower amid the escalation of inflationary risks. As recently published by the IMF, we are amid a difficult globally synchronized monetary tightening cycle that has led 75 central banks to increase rates since July 2021. Although economists and market pundits often reference the strong fundamentals of the US household and corporate markets (as measured by net worth and balance sheet stability) as reasons to forecast a mild recession, it is not difficult to imagine prolonged economic weakness. We are after all, in a synchronized global monetary tightening environment, where geopolitical events have the power to generate deep economic pain via energy markets, and government that will not have the same spare capacity to stimulate through fiscal instruments as debt levels increased dramatically post the COVID shock.
Having seen a tumultuous start of 2022, we expect the second half of the year to display the same level of volatility across asset classes. Expectation of volatility renders a reshuffling into assets with stronger fundamental pillars, healthier balance sheet risks, stronger collateral, etc. In fixed income, we must celebrate our call of maintaining short duration in all of 2021 and throughout the first half of 2022. Although our portfolios were not immune to spread widening, we avoided a significant portion of the negative returns experienced from the Barclays aggregate bond index by not having the same interest rate risk exposure. We have started to discuss and consider the reverse approach in risk exposure for the near future. Since markets appear to be stubbornly indicating that the Fed will have to implement a dovish shift as early as next year, the risk of interest rates for the medium term appears to be dramatically lower. This thesis, which by default contends for a limited upward move on long term interest rates, has been proven consistent in markets over the past couple of months. Even amidst month-to-month CPI inflation increases in May and June, the long end of the yield curve has failed to move higher. On the other side, spreads, the signal of credit and stress risk, have been increasing across the investment grade and high yield markets over the year. Although spreads have widened significantly already, they are far from historical levels experienced in recessions. A move to limit spread risk and embrace duration for its potential hedging power would be consistent with the current market shift away from inflation fears and into recession fears.
In some client portfolios, and where allowed by mandate, we moved in 2020 and 2021 away from public fixed income securities and into conservative private core real estate strategies, an action we will continue to deploy. It is proving to be a wise decision.
As previously mentioned, we are currently under a neutral equity mandate. Although we have not rebalanced amid the sell-off, meaning equity exposures are likely below neutral mandates, we have avoided decreasing or adding exposure amid the current volatility. As we alluded on the earlier macro discussion, prices have already corrected considerably, yet it is likely that we see another leg to this sell-off. As we avoid being very short-term allocators, our current discussions on the equity allocation have been around the best timing to go overweight equities in the future. Our recent line of thinking is that if the Fed is indeed forced to reverse policy and have a dovish shift, we will take the opportunity then to dial up equity exposure in portfolios. As per the composition of the equity exposure, we made a move in February of this year to decrease growth equity plays and added value and quality strategies. More recently, and building on our view of a strong dollar for the foreseeable future, we increased US allocation as the ex-US DM and EM markets have higher exposure to cyclical industries. The wild card, as often has been the case, is Chinese equities. China’s extreme zero COVID policy of eliminating outbreaks outright, has added further room of economic contraction and has muted the attractiveness of a cheap Chinese equity market that could benefit from sizeable potential fiscal and monetary stimuli.
We welcome the remaining months of 2022, with a very cautious and conservative allocation that is overweight cash and with higher quality in fixed income and equity exposures. We are keeping our eyes open and will closely follow inflationary prints, economic indications of further weakening, the USD moves vs. its main pairs, impact of tightening in financial conditions, energy geopolitical dynamics and the Chinese reopening process. It is difficult to be impassive and calm amid such an important economic story yet to unfold, however, remaining calm is what sets long-term investors apart.
JP Villamarin, CFA, CAIA
Senior Investment Analyst at Intercontinental Wealth Advisors
Chart 1. Reference Indices YTD and 1y as of July 19th, 2022
This information is prepared internally and sourced from the Bloomberg terminal.
Markets are constantly changing. Market Update information is a snapshot in time intended for information purposes only. Intercontinental Wealth Advisors, LLC offers various strategies and different strategies may have different market outlooks.