Managing Rising Rates and Inflation

With even core inflation, excluding food and energy, hitting more than three times the Federal Reserve’s 2% target, the data gives the central bank less flexibility to shield markets from volatility. This is especially true as the data relates to a period before the last peak in commodities, which will delay the decline in inflation we had forecast as economies normalize following the COVID-19 pandemic. We expect the Fed to follow up with a 25 basis point hike at its meeting this week, the first increase since 2018.

The European Central Bank adopted a hawkish tone last week and accelerated the reduction in bond purchases. So far, central banks appear to be focusing on inflation rather than seeking to offset any hit to consumer demand and businesses from rising commodity prices.

But while many investors may be tempted by the safety of cash in these uncertain times, the drag on returns from holding excess cash is greater in times of higher inflation and negative real returns. Instead, we recommend investments that outperform in this environment.

Fixed income opportunities remain. While the 10-year US Treasury yield climbed 23 basis points in the week to March 11, and continued to climb Monday to 2.07%, real yields are still unattractive at -92 basis points. We continue to see limited return prospects for US and Euro high yield credit. Investors can instead consider senior US loans, which offer an attractive yield and a floating rate structure that offers some protection against Fed rate hikes. The asset class is currently yielding 4.5%.

Global financials should benefit from periods of rising rates and steepening of the yield curve. We are neutral on European financials. Although exposure to Russia is contained and the macro backdrop still looks positive, this is already largely reflected in the price, in our view. We see greater upside potential for US financials, where valuations are more attractive.

While the U.S. yield curve has flattened recently, we expect the 2-10 part of the curve to steepen further to around 40 basis points by the end of 2022. The sector is also helped by improving loan growth and credit quality, against a robust global growth backdrop. Financials are also benefiting from the release of loan loss provisions.

Value sectors should outperform growth sectors as central banks tighten. Growth sectors, such as technology, tend to face the greatest headwinds as rates rise, since more of their value depends on more distant earnings. We maintain a preference for the US value, which is less impacted by higher yields and benefits from stronger economic growth.

So while we expect inflation to decline over the course of the year, the tightening momentum in central bank policy should persist. Click here to learn more about the preparation.

Main contributors– Mark Haefele, Christopher Swann, Vincent Heaney, Jon Gordon

The content is a product of the Chief Investment Office (CIO).

Original report- Managing Rising Rates and InflationMarch 14, 2022.

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