The US Federal Reserve took another decisive step this week to burnish its inflation-fighting credentials as it signalled an aggressive pace of rate hikes in the coming months. In doing so, Standard Chartered believes it has raised the odds of a US recession to 75% in the next 12 months. As flagged in recent months, the near-term implications are likely significant. By the year end, expect the 10-year US government bond yield to rise towards 4%, the 2-year yield to rise above 4.5%, and the USD to strengthen further, resulting in a further drawdown in equities.
The Fed, besides delivering its third consecutive 75bps rate hike, projected the benchmark rate to rise 125bps in the remaining two meetings of this year and another 25bps next year to a peak of 4.75%. Almost a third of the Fed’s 19 policymakers are more hawkish, projecting the so-called ‘terminal’ rate at 5% next year. That is steeper than the 4.5% money markets were pricing for the peak rate going into this week’s Fed meeting. The main message from the Fed was that it is willing to sacrifice growth to soften the US job market and accept an unemployment rate above its 4% long-term target so that it can sustainably bring down inflation towards its 2% goal.
As higher rates eventually lower growth and inflation, the central bank expects to cut rates in 2024, a year later than previous market expectations. At his press conference, Fed Chair Powell gave three conditions for pausing or slowing the pace of rate hikes: below-trend growth, softer labour markets, and clear evidence that inflation is moving back to 2%. Based on the latest projections, while growth is expected to remain below trend until 2024 – driving up the unemployment rate to 4.4% by next year – inflation is not expected to return to the 2% target until 2025. This week’s lower-than-expected jobless claims is only likely to embolden the Fed. This portends higher-for-longer rates, in our view, which is likely to tighten global financial conditions, especially with the ECB and the BoE also hiking rates (the BoE delivered a 50bps hike this week to a 14-year high of 2.25%, even as it warned that the UK economy likely contracted again in the July-September quarter).
SC prefers a three-pronged approach (the ‘3 Ds’) to mitigate the impact for investors: 1. De-risking of allocations by reducing exposure to equities and government bonds, which are among the most vulnerable to rising rates; 2. Diversifying into less volatile and high-quality USD-denominated Investment Grade corporate bonds in Asia and the Developed Markets (DM), which now carry the added attraction of paying the highest yields in a decade; and 3. Increasing exposure to other income assets, including a basket of consistently high dividend paying equities, which tend to outperform in high inflation regimes.
Within equities, the de-risking could start with reducing exposure to Euro area equities, especially with the rising risk of another Russian incursion into Ukraine. There is also the risk of Russia cutting off oil supplies after having already sharply cut gas supplies to Europe. Meanwhile, the US S&P500 index, which entered a bear market this week for the second time this year, is likely to test June’s intra-day low of 3,637. Momentum indicators show US stocks are oversold in the near-term, but a break below June’s lows could lead to a test of 3250-3540. Stocks in Asia ex-Japan and UK offer much better value, in our view, given their 28% and 45% price-to-earnings discount vs. US equities. Asia ex-Japan stocks have the added advantage of a steady stream of policy stimulus from Mainland China. Next week’s China business confidence indicators (PMIs) will be closely watched for signs of further economic recovery.
Asia and DM USD-denominated corporate bonds are top picks in bonds given their relatively low volatility and yields above 5%, which are likely to cushion against further rise in government bond yields. These bonds have historically delivered some of the highest returns in an environment of slowing growth and rising inflation. They also provide exposure to the rising USD, which we expect to strengthen further in the next 3 months, despite Japan’s FX intervention to revive the JPY. History suggests unilateral FX interventions provide only a short-term respite, but underlying fundamentals (rate differentials) prevail over the medium term.
By Rajat Bhattacharya for Standard Chartered
