investment insights
Rising rates don’t yet turn the tide for investors
Lombard Odier Private Bank
Key takeaways
- The Fed surprised markets with reference to pare back its balance sheet as it embarks on monetary policy normalisation
- Tightening monetary conditions open a new phase in the economic cycle
- Real yields are rising in the US but remain historically low
- Our portfolio positioning favours equities while growth remains strong. In fixed income we prefer Asian credit in US dollars and Chinese renminbi-denominated debt.
Haunted by 2013’s ‘taper tantrum,’ the US Federal Reserve has worked hard to signal monetary policy changes through the pandemic. Having prepared markets for accelerating normalisation to tackle high inflation, this month the central bank surprised investors by announcing the need to reduce its balance sheet. Tightening monetary conditions, along with higher rates, open a new phase in the cycle.
With US inflation reaching a 39-year high of 7% in December, containing prices has suddenly become a priority. Last week, a Federal Reserve Governor, Lael Brainard, said that returning inflation to 2% without disrupting the US recovery was the central bank’s “most important task.”
This isn’t an entirely new focus. In December, the Fed switched from treating inflation as a ‘transitory’ distraction to demanding rate hikes, as data pointed to broader spill-over effects. Where its average inflation targeting (AIT) allowed the US central bank to look beyond short-term spikes, the strength of 2021’s economic rebound, along with supply-chain problems and high energy prices, contributed to accelerating the need for normalisation.
In response to high inflation and rapidly-recovering job markets, the Fed said that it planned to end emergency asset-purchases this March and indicated at least three increases in its benchmark interest rate in 2022. The yield on the US 10-year Treasury bond has risen to 1.78% this year, a level not recorded since before the pandemic in January 2020. The equivalent German Bund also rose, to trade close to zero for the first time since May 2019, yielding -0.09% last week.
However, noises about reducing the size of its balance sheet – published in the Fed’s December meeting minutes on 5 January – came as something of a surprise. Through its asset purchases, the Fed has more than doubled its balance sheet since the start of the pandemic: total assets leapt from USD 4.2 trillion in February 2020 to USD 8.8 trillion at the beginning of this year, equivalent to 40% of the country’s gross domestic product.
Real yields start to move
Why does that matter to investors? During the pandemic, the combined strategy of buying sovereign bonds – limiting the pool of ‘safe’ assets available to investors – along with historically low interest rates, calmed markets and pushed equity indices to record highs. With that support unwinding and rates poised to rise, real yields – adjusted for inflation – are starting to move. This will have implications across asset classes.
The economic question is at what point rate hikes begin to restrict US growth. For an answer, we can look at the cost of capital, comparing the economy’s potential output growth with 10-year interest rates adjusted for inflation. Real rates have risen from -1% at the start of this year to around -0.75% currently, their highest level in nine months. Yet in historical terms, they will remain low. Even 2022’s three projected 25 basis point hikes may struggle to take real US rates positive this year. The previous cycle peaked in 2018 with real rates at 1%, and the 10-year nominal rate at 3%.
Meanwhile across the Atlantic, the European Central Bank also plans to end its pandemic-related asset purchases in March, but has indicated that it does not plan to raise rates this year. At the Bank of England, the interest rate hiking cycle began in December with a rise of 15 basis points. In contrast, the People’s Bank of China is moving in the opposite direction, loosening monetary policy in order to defend economic growth, which slowed through 2021.
Preparing for higher rates
What does this mean for asset classes? We expect equities to perform well through 2022, absorbing the impact of rate hikes as long as economic growth and activity remain strong. In this inflationary environment, investors will favour firms that are better able to protect their revenues from rising costs. Specifically, we see value stocks being well supported. To a lesser degree, selective cyclical names should also benefit from solid economic activity, while small capitalisations look attractively valued.
In past rate-hiking cycles, corporate credit tended to outperform sovereign debt, as spreads narrowed, partly absorbing the impact of rate increases. In 2022, this may be more difficult. Yields are lower overall and spreads narrow by historical standards. With government yields set to rise over 2022, our end-of-year expectations for 10-year US Treasuries and German Bunds are 2.25% and 0.25% respectively.
In line with policy normalisation expectations in both the US and eurozone, we generally prefer short-duration bonds and corporate debt with floating rates. At an asset class level, we underweight both sovereign bonds and investment grade credit, in favour of Asian credit in US dollars and Chinese debt denominated in renminbi, which offer portfolio diversification.
While real rates remain negative, meaning that holding cash comes at a cost, we increased our cash positions in November. In an environment of rising volatility, this will let us seize investment opportunities to reinvest in risk assets.
Gold, the traditional haven investment from inflation, has been held back by a stronger dollar and the expectation of higher rates. Historically, gold tends to suffer ahead of a first interest rate increase – and more so if the market begins to price in rate hikes earlier than previously expected. Once the hiking cycle begins, gold’s performance depends on whether monetary policy continues to target inflation. Overall, the faster inflation falls and real rates increase, the greater the pressure on gold prices. We expect gold to head lower this year, eventually trading down towards USD 1,600 per ounce, and remain underweight the yellow metal.
Other commodity markets, such as crude oil, copper and agricultural raw materials, are less directly affected by monetary policy and more by growth activity and supply levels.
We expect the US dollar to strengthen and the euro to weaken in 2022, while the renminbi should remain stable in the first half of the year. The euro-dollar may remain under pressure, assuming global growth slows to trend and as long as the ECB lags the Fed’s tightening pace. China’s strong external balance, and the fact that the bulk of its debt is financed in renminbi, should limit the Chinese currency’s sensitivity to higher US yields compared with other emerging currencies.
Wichtige Hinweise.
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