Capital Ideas^TM

Markets rebounded in the fourth quarter of 2022, closing a year marked by high volatility as the US Federal Reserve (Fed) reset its monetary policy path. US equities gained, credit spreads tightened and interest rate changes moderated over the quarter. Nevertheless, the Bloomberg US Aggregate Index ended the year down 13.0%, its worst return on record, and the US 10-year Treasury climbed 237 basis points to 3.88%, the largest calendar year increase in at least 60 years. Looking ahead, similar concerns to those of 2022 linger: How much more could the Fed hike and the repercussions of tighter policy on growth momentum. A silver lining, though, is that bond prices now reflect more Fed tightening and offer higher compensation for the uncertain outlook.

Inflation rates remain uncomfortably high globally, although there are signs that it has peaked in some regions. The US, UK, and European Union have all reported inflation decelerating, but the timing for the rate of price increases to return to central banks’ target levels is unclear. In the US, a buoyant labour market, “sticky ”shelter inflation, service sector resiliency and elevated wage growth may keep inflation stubbornly higher than targets for longer than markets expect.

Central bank policies will likely remain restrictive, though the pace of tightening is likely to slow. Following one of the sharpest shifts in central bank policy in decades across many developed markets, policy rates are already in a range that is likely to restrain growth momentum. The distance to the rate that marks the peak of the tightening cycle may be closer, even if there’s uncertainty about where that terminal rate will eventually settle. The Fed is likely to move at a more measured pace than the large increases that characterised many of the policy rate changes in the second half of 2022, though the path of inflation will be critical. 

A shift in the Fed’s stance to end rate hikes is probable this year, though a pivot to cuts is less so — particularly if higher inflation rates linger.

Growth momentum is slowing globally, with tighter financial conditions likely to weigh on the global growth outlook for 2023. However, there have been signs of resiliency, particularly in US labour markets even as economic activity slows. In fact, measures like the ratio of job vacancy to unemployment remain at historically high levels even as it may be trending down. In Europe, the economic slowdown amid high inflation and an energy crisis may not be as bad as investors previously feared, with the European Central Bank recently showing only modest downward revisions to GDP growth even with substantial upward revisions to inflation. China, facing stalling growth and a myriad of other challenges, surprised markets with a reversal in its zero-COVID policy. The potential for a higher rate of infections creates much uncertainty in the near term, though a broader economic reopening may offer more ballast than previously expected to global growth later in the year.

Relative value opportunities look compelling even with an uncertain backdrop. Ultimately the macro backdrop is one where growth momentum is likely to slow, though the extent is less certain. If inflation trends lower, there may be less rate volatility as central bank hawkishness moderates. Valuations broadly appear better than a year ago, even with the recent rally in the fourth quarter. Importantly, dispersion within many sectors offers attractive bottom-up opportunities, from yield curve positioning to relative value in the mortgage coupon stack to security selection within credit. These opportunities should pair well with higher starting yields, which can enhance total return potential and also provide an income offset should price volatility rise unexpectedly.