The word pivot has a good chance of being voted word of the year 2022 in the financial world, or at least reach the top 10. Since the Federal Reserve has adopted its fastest and steepest tightening cycle in the last 30 years – with multiple interest rate steps of 75 basis points – investors have been longing for a pivot, or in other words, a turnaround by the Fed from a restrictive back to an expansionary monetary policy. This would actually be a classic pivot. By contrast, the throttling of the pace of monetary tightening now anticipated by the markets – from 75 to 50, or even 25 basis points – is not a true pivot. Currently, financial markets assume that the Fed will pause in 2023 and that federal funds futures will remain above 4% until early next year.
Believing that capital markets would behave in a manner analogous to the last decade, many investors wish the Fed would reach its pivot rather early than late. Why? Because after each reversal of monetary policy, a strong rally in risky securities followed. For example, we remember the turn of 2018/2019, when Fed Chairman Jerome Powell switched his communication from autopilot mode to a classic pivot. As a result, stock markets staged a massive recovery in the months thereafter. However, the current macroeconomic environment is now nothing like that of the last 15 years, and the US central bank, due to the record high inflation, has never had so little flexibility since the great financial crisis of 2009.
At best, the current setup is comparable to the situation in 2001, when equity markets fell despite interest rate cuts of over 400 basis points. The backdrop was the collapse in growth following the implosion of the dot.com bubble and the terrorist attacks on September 11, 2001, so markets should be careful what they wish for. We think that the Fed hardly has the flexibility for a classic pivot in the coming months. However, if it does, the Fed's motivation would likely be an unforeseen slump in economic growth or an external shock. Either situation would typically be a huge headwind for risky asset classes.
On this side of the Atlantic, we have to make the sobering observation that neither the European Central Bank (ECB) nor the Bank of England (BoE) have any room for maneuver to deviate from their restrictive monetary policy in the foreseeable future. While in the US the Fed has the option of using QT (quantitative tightening or reduction of the central bank balance sheet) or of resorting to other instruments, this flexibility is lacking in Europe. The ECB has virtually no room for maneuver due to the periphery spread, i.e., the different effects of a more restrictive interest rate policy on financing conditions in the euro countries. For its part, the British central bank must prevent a further distortion in the bond market.
The mix of economic growth and inflation as well as restrictive monetary policy continue to be the two main headwinds for risk assets. In our view, the time is not yet ripe to broadly build up risk in the portfolios. For years before the corona crisis, there were hardly any alternatives to equities – we remember the buzzword TINA (There Is No Alternative). Now, however, there are again reasonable alternatives for investors under the motto: TARA (There Are Reasonable Alternatives). Across all assets, the bond asset class has come to the fore in recent months, as investors can invest their money at attractive yields in the short-term. In addition to government bonds, we now also see potential in high-quality corporate bonds.
In equities, we remain defensively positioned and focus on selection. We see a gradual improvement in emerging market equities, but think it is still too early to build up positions. The big unknown remains the reopening of China's economy against the backdrop of renewed pandemic flares and the government’s zero covid policy. At the sector level, we now favor banks and upgrade them from neutral to attractive. Conversely, we reduce telecom companies from attractive to neutral.
We maintain our neutral duration strategy and do not yet see the time to buy the long end in both the United States and Europe. We now see return potential in corporate bonds again, which is why we are raising our rating from neutral to attractive and preferring the segment as an investment opportunity. After a solid performance of threshold country bonds in hard currencies, we reduce our rating from neutral to unattractive and avoid this segment.
In the challenging macroeconomic environment, we are sticking to diversifying building blocks such as hedge funds. Both real interest rates and the US dollar should be past most of the rise that has acted as a strong headwind for gold. In periods of weakness, we would start to rebuild gold.
Publisher: LGT Bank (Switzerland) Ltd., Glärnischstrasse 36, CH-8027 Zurich
Author: Thomas Wille, Chief Investment Officer, Email: email@example.com
Editor: Alessandro Fezzi, E-Mail: firstname.lastname@example.org
Source: LGT Bank (Switzerland) Ltd.
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