Capital Ideas^TM

• Volatility likely to continue as uncertainty remains high
• Much higher inflation may keep the US Federal Reserve (Fed) on tightening path in near-term, even as growth weakens
• Global growth backdrop is deteriorating, particularly in Europe and China

Sharp shifts in expectations for central bank policy and the resultant market volatility underscore the challenges facing investors. The third quarter featured a tale of two halves: An initial rally across markets turned into a sell-off. Hopes for less restrictive central bank policy were dashed by higher-than-expected inflation data and more hawkish central banks globally. Interest rates rose, credit spreads widened and equities fell broadly in August and September. Wide trading ranges in global interest rate markets in particular reflect the swings in prevailing expectations for central bank policy. This volatility is likely to continue as uncertainty remains high and growth momentum slows globally.

Fiscal developments in the UK in late September exacerbated the volatility in markets. A plan from the new UK government to add fiscal stimulus sent interest rates soaring and the pound sterling plunging. Within days of the announcement, short- and long-dated UK gilts rose over 100 basis points (bps), prompting an emergency bond-buying operation from the Bank of England to help counter a liquidity crisis for the country’s pension plans. Global rates in turn followed UK gilts higher while risk assets struggled.

Central banks globally re-affirmed a commitment to reducing high inflation. The Fed and many global counterparts pushed back on the market’s initial expectations for less aggressive monetary policy. Fed Chair Jerome Powell delivered successively hawkish messaging on the committee’s focus to slow inflation. Two large 75bps hikes during the quarter brought the policy rate just shy of 3.25%. The European Central Bank also delivered large (50- and 75-bps) hikes while central banks in Canada and Sweden each surprised with a 100 bps hike. The synchronised rate increases underpin a broad tightening in financial conditions that we expect to continue. With market expectations for Fed policy rates to now peak over 4%, pricing of front-end yields looks reasonable. 

Inflation remains stubbornly high. Even as the overall rate has shown signs of potentially peaking, underlying trends indicate much more broad-based inflation. Measures that focus on “stickier” elements of inflation remain elevated. Additionally, wage growth has accelerated, raising the potential for inflation to remain at elevated levels. While inflation will likely decelerate over time from today’s high levels, markets may be underestimating the time it may take to reach levels more acceptable for the Fed. This will likely keep pressure on the Fed to remain on its tightening path, even as growth conditions worsen. 

The global growth backdrop is deteriorating. In the US, consumption held up relatively well amid rising wages, tight labour markets and credit growth. However, domestic headwinds are growing as consumer and business sentiment have soured while key sectors of the economy like housing are slowing alongside higher interest rates. Services and manufacturing sectors have shown a slowing trend — similar to other developed markets — though still remain expansionary. In Europe, an energy crisis along with historically high inflation pose significant growth headwinds while UK’s stimulus plans may destabilise an already precarious fiscal position. Meanwhile the Chinese economy, a global growth engine, continues to struggle with zero-COVID policy, housing sector challenges, rising unemployment and lacklustre wage gains.

While valuations have broadly improved, we remain measured in our risk posture given the rising uncertainty in the global outlook. The recent rate volatility and subsequent increase in rates has improved the attractiveness of interest rate exposure. In addition, starting yields for many credit-related assets are noteworthy, though valuations may still cheapen given elevated recession risks in the near-term. Even so, compelling idiosyncratic opportunities remain as improved compensation can help balance macro uncertainty.