Saber-rattling over the Russia-Ukraine border no doubt contributed to declining equity markets in late January. But the big driver, of course, was the Federal Reserve’s new messaging that the end of quantitative easing (QE) this year would quickly be followed by the onset of quantitative tightening (QT). Of course, shrinking the balance sheet is just another form of tightening, yet in contrast to centuries of experience with rate increases, we have little to go on to gauge the impact of QT on markets and economies. Nonetheless, it certainly appears that the tightening of liquidity ahead will feature fewer rate hikes and more balance sheet shrinkage.
Judging by the calm at the long end of the rates curve, the bond market appears to view this tightening cycle as an echo of 2017-2019. In those pre-Covid days, with unemployment slightly below 4% and core personal consumption expenditures (PCE) inflation slightly above 2%, the Fed began tightening by allowing maturing securities in its balance sheet to run off. That worked until equity markets balked at Chair Powell’s description of such balance sheet shrinkage as “on autopilot” – and with little precedent as to what this would mean for the economy and markets, stocks dropped precipitously. Eleven days later, the Fed relented, tempering its language.
Of course, that was a different world: The economy was still fragile, and China was piling on to the Fed’s tapering with its own shadow banking reforms, creating air pockets in both its own expansion and global growth, exacerbating the fragility of the time.
Today, headline inflation is at 7%, with wage pressures and loan demand rapidly accelerating. The Fed is trying to play catchup, although even its articulated tightening still leaves rates well below where inflation is likely to be at the end of 2022 – perhaps leaving too much incentive to borrow, invest, and spend now.
Why will this burgeoning inflation be tamed by such gentle medicine? Demand drivers this time around are incredibly strong, not fragile, with corporate profits powering ahead. The Fed also stands alone among the world’s major central banks in this tightening cycle. Last time, other central banks were expected to follow the Fed’s lead. This time, many emerging central banks have been raising rates for several quarters and have already caught up with inflation. When inflation does break, they will be positioned to ease while the Fed is still trying to catch up. While the Bank of England is likely to be in lockstep with the Fed, the People’s Bank of China (PBOC) has just begun easing. The European Central Bank and Bank of Japan will be sitting on their hands well into 2023. So the Fed’s solo act does not augur a world soon to face a global liquidity crunch.
What’s more, the level of dry powder at US public companies and in the private-equity sector is unprecedented. Bank loan-to-deposit ratios are below 50%, with lots of firepower to boost that ratio even as the Fed shrinks excess reserves via QT. And while China, the world’s other bookend, was piling on with its own policy restraint in 2018, this time it is out of sync. While the Fed was pumping liquidity last year, the PBOC was tight as the nation pursued disruptive regulatory reforms in major sectors. As the Fed tightens, the PBOC will not only be easing, it will be relaxing or reversing many of 2021’s regulatory restraints. Modest tightening is being applied to an overheating, not a fragile, world.
If equity investors give ground in February as they did in January, might the Fed be rattled enough to hoist the white flag, ending QT prematurely? Job No. 1 is still curbing inflation, and while the goods-related bottlenecks driving the 7% headline figure may start clearing, services are much larger and are just beginning to trend higher amid accelerating wages and bank lending. With today’s demand shocks just as culpable for inflation as supply bottlenecks – no doubt fueled by the Fed’s prior policies – higher rates could help cool overheating in the housing market while business investment powers on to meet strong demand. More restrained domestic liquidity might also deflate asset prices enough to mitigate social pressures caused by widening income and wealth inequality – items important to this evolving Fed.
While the economy is positioned to handle more restraint this time around, the Fed is likely to show more resolve. This year’s “Fed put” is likely far below what the bond market now expects.
Conviction Score (CS) and Investment Views
The Conviction Scores shown below reflect the investment team’s views on how portfolios should be positioned for the next six to nine months. 1=bullish, 5=bearish, and the change from the prior month is indicated in parentheses.
Global Economy
Markus Schomer, CFA
Chief Economist,
Global Economic Strategy
CS 3.00 (+0.25)
Stance: While downgrading the macro score to a neutral 3, we still expect global GDP growth to remain above the long-term average in the next few quarters. But the downside risks to our “soft landing” base case are increasing, and further risk events are entering the framework horizon – in particular the US mid-term elections and the deteriorating geopolitical environment, notably the Russia/Ukraine crisis.
Backdrop: Preliminary purchasing managers’ index (PMI) readings show a more noticeable slowdown in services activity in major developed market (DM) economies, which may be another temporary Covid-related bump. But it comes on the heels of rising expectations of more global central bank tightening, fading hopes for more fiscal spending in the US, and the risk of a military conflict between Russia and Ukraine. Some see an offset to clouds over the US and Europe in growing stimulus efforts in China. Yet China’s actions highlight weakening in its economy due to tech crackdowns and its zero-Covid policy. Despite downside risks for the first quarter, global growth is still expected to remain well above long-term averages on the back of strong excess demand that should drive wages and sales, as well as some residual positive effects from the eventual easing of remaining pandemic-related economic constraints.
Outlook: While the near-term outlook is less certain, the intermediate-term outlook remains positive. There is still a lot of excess demand in the system and more catch-up potential of economies versus the previous cycle’s trend. Monetary policy may be tightening but should remain growth-supportive for awhile, and some fiscal spending is likely in the US and in Europe.
Risks: Fed tightening into a more serious economic slowdown; a more serious market crash in anticipation of this scenario; and a Russian invasion of Ukraine are risks to watch.
Rates
Gunter Seeger
Portfolio Manager, Developed
Markets Investment Grade
CS 3.00 (unchanged)
We expect the Fed to tighten (although probably not as much as they say they will) and the equity markets to sink in response. The question is whether the Fed will eventually relent and again ride to the rescue.
Credit
Steven Oh, CFA
Global Head of Credit and Fixed Income
CS 3.50 (+0.25)
Credit markets fared better than equity markets in late January, with only slight spread widening. Fundamentals should continue to support credit prices, but valuations are far from cheap and would limit value buyers at current levels. In emerging markets (EM), we’ve seen additional negative sentiment on China property recently.
In anticipation of Fed rate hikes, demand for leveraged loans and collateralized loan obligations (CLOs) has grown, while the rise in total yields for intermediate credit should start to appeal to yield-focused buyers. That rise and fixed-spread widening argues for trimming overweights to floaters. We also continue to prefer investment grade (IG) credit over high yield.
Currency
(USD Perspective)
Anders Faergemann
Managing Director,
Senior Sovereign Portfolio
Manager, Emerging Markets
Fixed Income
CS 3.00 (unchanged)
Due to the recent rise in US Treasury yields, the onus is now on the Fed to support the US dollar. Typically, the first Fed rate hike signals a turn in the US dollar, adding to the narrative that the US dollar faces an uphill struggle to make further gains unless new information arrives. Monetary policy divergence between China and the US has yet to play out in the FX market. The Chinese renminbi has held onto its gains beyond what would normally appear reasonable as the economy has suffered a self-inflicted slowdown. Ironically, any signs of a Chinese policy reversal that would add stimulus could prompt US dollar weakness as historical data suggests the US dollar is inversely correlated with China’s economic cycle. For the euro to take advantage of US dollar fatigue, the eurozone will need to recover faster, posing challenges for the European Central Bank, which will aim to unwind its emergency liquidity before raising rates. In contrast, EM central banks are well ahead of the major central banks in normalizing policy. Some Latin American central banks may even be close to ending the tightening cycle, having generated a sufficiently large policy buffer, supporting local rates and exchange rates.
Emerging Markets
Fixed Income
Chris Perryman
Senior Vice President, Corporate
Portfolio Manager and Head of
Trading, Emerging Markets
Fixed Income
USD EM (Sovereign and Corp.)
CS 2.50 (unchanged)
Local Markets (Sovereign)
CS 2.25 (unchanged)
Our scores and global macro scenarios are unchanged, with emerging markets well prepared for the Fed’s shift in rhetoric and any tightening. EM credit fundamentals are on a firm, upward trend. Corporate fundamentals are strong across regions (except China property), as companies used the 2020-2021 low-rate environment to manage their balance sheets and debt maturities. EM defaults have surprised to the downside, running below historical 2% levels. We trust the corporate universe to rely on their balance sheet strength to fend off Fed hikes. For EM corporates, developments in ESG and the transition to cleaner energy can be drivers of long-term outperformance. For EM sovereigns, the normalization of global growth does not translate into a negative. Rate hikes by EM central banks in 2021 have generated positive real rates, which is not directly growth negative and also reduces reliance on fiscal support.
Multi-Asset
Peter Hu, CFA, FRM
Managing Director, Portfolio
Manager, Global Multi-Asset
CS 3.15 (unchanged)
Markets appear willing to look past the near-term impact of the omicron variant on growth due to shutdowns, except in China, which may continue its zero-Covid policy and lead to lockdowns and disruptions in the global supply chain. On the flip side, Chinese policymakers appear ready to ramp up stimulus, which we expect will target higher value-added manufacturing and climaterelated sectors. In the US, we see less fragility and more sustained above-trend growth, leaving us optimistic about the economic impact of the first several rate hikes. Couple US tightening with stimulus in China and we foresee excess demand shocks as well as supply shocks, but business investment rising to the occasion to address both. Households are no longer deleveraging; on the contrary, demographics and work-from-home shifts are driving a new wave of first-time homeowners. Climate urgency also will boost investment.
In advance of potential Fed tightening, we have been gliding our score from a bullish 2.2 to a modestly bearish 3.15 over the past several months. We continue to view today’s overheating as unfavorable for risk assets.
Real Estate
Marc-Olivier Assouline
Principal, Real Estate
The focus on ESG has intensified over the past six to 12 months. While environmental issues have long been a concern, as property and construction sectors account for about 40% of all CO2 emissions globally, the industry is grappling with how to measure social and governance factors, which had been largely neglected. Currently, changing use patterns are exacerbating dramatic undersupply in logistics and in institutional rented residential, senior living, and student housing, sectors that are attracting capital. While supply-chain bottlenecks are easing, risks include funding gaps due to hesitancy from traditional banks to finance development, profit erosion due to rising costs, and inflation-related interest rate increases, which would cause substantial value erosion.
Global Equity
Rob Hinchliffe, CFA
Managing Director, Portfolio
Manager, Head of Sector
Cluster Research
CS 3.00 (unchanged)
While the market is debating the potential impact of Fed tightening, the strong overall demand outlook has not changed. Furthermore, we see potential offsetting impacts from central bank easing in Asia and Europe and signs of fewer supply chain bottlenecks, which may tamp down inflation in the months ahead. Valuations for many B-tier companies are becoming attractive, with multiples compressing toward pre-Covid levels despite larger total addressable markets. We expect volatility will persist as the macro debates play out, which emphasizes the continued importance of portfolio balance.
Global Emerging
Markets Equity
Taras Shumelda
Portfolio Manager,
Global Equities
CS 2.25 (unchanged)
We maintain our moderately bullish score because despite volatility and several challenges in the US and globally, the market’s breadth is improving. In China, property sector pressures continue while higher raw materials costs have led to price hikes in select categories. Although in its early stages, policy is turning positive. In India, most leading IT companies report decent growth, automobile volumes are tepid, and many manufacturing companies see higher raw materials prices and international logistics as key near-term challenges. Our portfolio companies continue to report positive revisions, although smaller in magnitude than in previous periods. In Latin America, macro headwinds are weighing on the market despite decent company results. In emerging Europe, Turkey’s self-inflicted macro pains, new shutdowns in the EU, and the risk of armed conflict in Ukraine weigh on equity markets, although company guidance from the CE3 is positive. Asia financials and CEE consumer discretionary look attractive. Many EM companies exhibit improving ESG metrics and strong management and are well-equipped to withstand the current challenging global environment.
Quantitative Research
Haibo Chen, PhD
Managing Director, Portfolio
Manager, Head of Fixed Income
Quantitative Strategies
Our US Market Cycle Indicator is moving toward neutral, driven by a flatter curve (-12 bps), which outweighs the BBB spread tightening of 6 bps in December. The short end of IG and HY spreads each look rich. In industry selection, our model favors natural gas, energy, and electric and dislikes communications, transportation, and capital goods. Our global rates model continues to forecast lower yields and a flatter curve, but with smaller magnitudes. The rates view expressed in our G10 model portfolio is overweight global duration. It is underweight in North America (underweight US and overweight Canada), overweight Europe (overweight peripheral and underweight core countries), overweight Australia/New Zealand, and underweight Japan. Along the curve, we are still positioned for flattening and are overweight the long end.