With the Fed in aggressive tightening mode, Ben Bennett, Head of Investment Strategy and Research at Legal & General Investment Management (LGIM), looks at the implications for equities, credit and government bonds:
The prospect of tighter monetary conditions – and how quickly they will tighten – has been the subject of intense scrutiny for investors since the start of the New Year. And with good reason.
The US Federal Reserve’s (Fed) hawkish pivot, the spike in real yields and the sharp increase in equity volatility also formed the main topics of conversation at our latest strategy week, when LGIM’s investment professionals discuss the market outlook.
Given no one (not even the Fed) knows how to calibrate monetary policy tightening perfectly, there was some trepidation that we are at the start of a cycle that would lead to higher volatility and potentially lower returns over the medium term.
Is the equity market correction overdone?
The consensus view was that the recent equity market correction is probably overdone in the near term. Broadly, we don’t believe funding conditions have tightened significantly and we think economic growth should remain robust in the coming quarters; this should translate to improving corporate fundamentals.
Notably, we think the US domestic economy is less sensitive to interest-rate hikes than in the past. We also believe that emerging markets are not as susceptible to tighter US dollar funding conditions as in previous cycles. Nor do we think that there are any obvious asset-price bubbles that will be burst by tighter monetary policy. Even if cryptocurrencies collapse, the overall impact on household wealth would be relatively small, in our view.
Our bias is, therefore, to buy into the weakness, although this is a clearer decision for equity markets than credit, where the move has been less pronounced, and issuance has been heavier than expected. Indeed, looking ahead, we expect M&A activity and capex to pick up this year, which could also be more positive for equities than credit.
Of course, there’s always the risk that market volatility feeds back into lower risk appetite, consumption and investment, ultimately leading to a weaker economy. This tightening cycle could be particularly problematic given the inflation backdrop. In other words, the Fed put might be quite some distance away.
Possible downside risks to growth
We also discussed the growth downside risk posed by high energy prices. This is particularly acute in Europe and the UK – and is currently exacerbated by tensions between Russia and Ukraine. We don’t think the situation threatens an immediate recession, but we will continue to monitor it.
The third risk we debated was that of a severe Omicron outbreak in China, which could lead to widespread lockdowns that disrupt economic activity and global supply chains. This would be an unambiguously negative mix of higher inflation and lower growth. However, Chinese policymakers have already shifted to a more supportive fiscal and monetary stance and would presumably go further under such a downside scenario.
Still positive on risk assets
That all said, we remain generally positive across risk assets, although we have concerns surrounding the tighter parts of the credit market. We think government bond yields have a bias to rising in coming months, but it’s unlikely to be a straight line, and we may tactically moderate our view following large moves like those we’ve seen at the start of the year.