‘Transitory inflation’ made a swift exit from the vocabulary of the major central banks as constant high inflation numbers forced the hand of policy makers to pursue a rapid tightening cycle.
This plan was put to the test when Russia invaded Ukraine, leading to a downward revision in growth projections for the coming year, particularly in Europe. Moreover, this conflict added to further supply chain disruptions, with Russia a significant energy and metals supplier to mainland Europe.
Hence, the recent communications by the Federal Reserve (FED) and Bank of England (BOE) were highly anticipated as they provided clarity about the speed at which they will be implementing their tightening programmes. The FED hiked by 0.5% and set the pace for two additional 0.5% moves in June and July. More importantly, the FED dismissed chances of a 0.75% move hike to reduce fears of a disorderly tightening.
On the other hand, the BOE hiked by 0.25% while noting that global inflationary pressures are forecast to build further in the near term, peaking above 10%, before falling back sharply. Growth projections were downgraded to 2.5% in 2022 and 2% in 2023.
The consequent impact of the tightening cycle and lower growth projections led to a flattening of the yield curve and hence an increase in recession risk over the coming 18 months. A flattening yield curve occurs when short term rates increase more than long term rates. Such a movement reflects the expectations of rate hikes in the near-term while being more sceptical of the economy’s outlook.
This scenario has let investors with nowhere to hide this year with both fixed income and equities registering significant Year-to-Date losses. A repricing shock for Investment Grade bond investors after 16 years of constant loose monetary policies which led to a 65% return by the European Investment Grade space over this period.
The tightening cycle is a reversal of the policies mentioned above as the increase in reference rates has a negative correlation to bond prices, while the phasing-out of the Purchasing Programmes is reducing demand for the Investment Grade space. Hence, the main sources of the recent downturn in the Fixed Income market are duration and credit spread risk.
Duration risk is the risk that changes in interest rates that will either increase or decrease the market value of a fixed-income investment, while credit spread is the difference in yield between a benchmark rate (e.g. US Treasury or German Bund) and another debt security of the same maturity but different credit quality. The current monetary policies have led to a higher differential, adding further headwind to Investment Grade Corporate bonds.
From a portfolio management perspective such a scenario highlights the importance of active management in both the fixed income and equity space. On the fixed-income side, active fixed income fund managers had to reduce the duration of their respective portfolios significantly to protect their investors from the spike in yields.
Inflation numbers, the war and growth forecasts will continue to dictate the direction of the markets
On the equity side, the rising yielding environment heavily penalised growth stocks, particularly the technology sector as it included equities with very expensive valuations at the beginning of the tightening cycle.
Passive investors who had a high concentration to technology stocks after a 97% return over the period March 2020 – December 2021, are looking at an average loss of around 25% year-to-date. A significant lag to the year-to-date performance of energy and metals stocks which were driven by the soaring commodity prices.
Volatility is expected to remain elevated as inflation numbers, the Russia-Ukraine war and growth forecasts will continue to dictate the direction of the markets in the upcoming months. Retail investors could limit the effect of such volatility by having cash available to tap the market in periods of significant downturn. Moreover, such capital injections should be spaced out to average the entry price of their investment.
Selection will be key for portfolio managers to create value for their investors by unearthing pockets of values within sectors that should hold their ground in such a scenario. The coming 18 months will require managers to readjust their allocation quite often as the major central banks will continue to unravel their tightening policies in parallel with unprecedented inflation numbers and downward revisions in growth forecasts.
The writer and the company have obtained the information contained in this document from sources they believe to be reliable, but they have not independently verified the information contained herein and therefore its accuracy cannot be guaranteed. The writer and the company make no guarantees, representations or warranties and accept no responsibility or liability as to the accuracy or completeness of the information contained in this document.
They have no obligation to update, modify or amend this article or to otherwise notify a reader thereof in the event that any matter stated therein, or any opinion, projection, forecast or estimate set for the herein changes or subsequently becomes inaccurate. BOV Asset Management Limited is licensed to conduct investment services in Malta by the Malta Financial Services Authority.
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