Inflation: investment alternatives in an adverse scenario

With higher rates in the market, is fixed income attractive again?

In 2022, monetary policy events in the US and the world have been the main driver of the performance of global financial assets. In particular, the different asset classes respond to the signals provided by the Federal Reserve regarding interest rates and monetary restrictions.

The prevailing volatility is largely explained by uncertainty regarding what will be the final phase of the interest rate hike cycle. The entity consolidated its policy turn in response to persistently high inflation, a problem also faced by several of the advanced economies.

In the latest week, the rate considered “risk-free” – the US 10-year Treasury bond – climbed to new highs for the year, trading above a 4.2% yield when at the start of 2022 it is around 1.6%. The last time Treasuries had reached this level was in 2007/08, some fifteen years ago.

Risk-free rate reaches a maximum of the last 15 years

10-year US Treasury bond yield, last 15 years.

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Source: Market Watch.

During September, the Federal Reserve increased its monetary policy rate by 0.75% towards the 3.00-3.25% range, and gave indications that the adjustment process had not come to an end. The probability of a new similar jump in November is high, and the futures market already trades with a final rate of 5% by March 2023.

This suggests that the US central bank will seek to rein in the economy harder than expected to deal with high inflation. At the moment, the resilience of inflation in a good part of the countries does not allow us to anchor expectations regarding at what level and for how long interest rates will stabilize.

This represents considerable pressure on financial assets, from fixed income to equities. The vast majority of asset classes have registered negative variations so far this month, something that is repeated in almost every month of this year.

The further pessimism was due to a rapid increase in prices in the US that showed no signs of easing in September. The rise in the headline CPI last month, including energy and food, rose 8.2 percent from a year earlier, little changed from the 8.3 percent annual rise recorded in August.

Beyond the ups and downs of the energy component, the services component continues to keep inflation high in that country, with the core basket exhibiting a worrying resilience for monetary policy makers.

In this sense, annualized six-monthly core inflation has been between 5% and 7% for almost 18 months.

Core inflation, persistent for 18 months

US Consumer Price Inflation, core basket, semi-annual, annualized.

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Source: Schrodders.

In this context, the markets incorporate a scenario of higher rates and for a longer time, as inflation becomes a problem that is difficult to eradicate. As a result of more restrictive interest rates, the risk of a recession in the US is looming, a factor that is captured in the inversion of the yield curve of that country’s Treasury bonds.

Recession on the horizon? The slope of the bond curve deepens investment

Slope of the US sovereign curve, 2-year vs. 10-year stretch

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Source: Schrodders.

Investment Recommendations

Even though there seems to be room for further rate hikes, we believe there is reason to consider selective opportunities in the short-term fixed income market.

For the first time in years, bonds today show relatively attractive real rates. During the era of negative or near-zero rates, the fixed income market was artificially nullified and with a meager performance outlook. However, now we are once again seeing rate levels that have not occurred for more than a decade.

Although there are risks mentioned above – greater adjustment by the Federal Reserve, persistent inflation-, we believe that this level of yields deserves a new consideration, since high rates operate as a buffer in case of new increases, before the investor suffers a capital loss.

In this sense, to take an example, the 2-year US Treasury bond (it came to yield practically zero in the midst of the pandemic, while today it generates an annual return of 4.3%) can withstand a additional 2.4% (240 basis points) rise in yield before generating a loss for the investor over a 12-month horizon. In turn, short and high-quality corporate bonds that offer returns of more than 5% per year, the “cushion” resists up to 3.2% (320 basic points) of higher rates.

Although 2022 is a bad year for the almost entire universe of financial assets to date, we believe that at these levels of rates and inflation there could be selective opportunities for a 12-month investment.

Asset Management Director at Criteria

Inflation: investment alternatives in an adverse scenario