Positioning for elevated inflation and recessionary risks

Last week brought another nasty inflation surprise. The persistence of inflationary pressures raises the risk of further rate hikes by the Federal Reserve, with fears of a hard landing exacerbating market volatility. Meanwhile, higher short-term interest rates are making cash alternatives seem a lot more attractive to investors looking to avoid further downside. We take a look at how investors should position for an environment of elevated inflation and recessionary risks.

Inflation once again disappoints

First, a recap of the movie we have already seen many times this year. The consumer price index (CPI) data for September once again came in far above consensus. Falling goods prices were offset by higher services inflation. More than half of the 0.8% month-over-month jump in core services was due to rents, which also accelerated 0.8%.

CPI rent data is a lagging indicator and is likely to show big increases in the next few months. The Fed knows this, but after being faulted for being behind the curve, its credibility is at stake; and given that inflation risks continue to be skewed to the upside, it cannot afford to rely on forecasts to set its policy. Plus, no matter how the data is sliced, wage growth remains too high for inflation to slow meaningfully toward the Fed’s target.

The strong employment and inflation data make it likely that the Fed will raise rates by 75 basis points at the next FOMC meeting on 2 November, and adds to the risk that it will hike by 75bps again in December or that the rate hiking cycle will continue into 2023.

Near term risk-reward unfavorable

With a Fed pivot unlikely in the near term and other global central banks' hiking cycles likely to continue until the first quarter of 2023, we expect global economic growth to continue to decelerate. The synchronous hiking of rates by global central banks is contributing to heightened volatility, and financial markets are likely to see pockets of vulnerability. This makes the outlook for risk assets unfavorable in the near term.

The picture, however, is likely to improve as we get further out into 2023 as economic growth troughs sometime in the first half of next year and markets start to anticipate a Fed rate cutting cycle. And at current valuations, the longer-term return outlook for diversified investors is relatively favorable.

As such, we believe investors should focus on mitigating near-term downside risks while retaining exposure to equities for medium- and long-term upside. We recommend considering downside risk mitigation strategies, including options or structured strategies.

Such strategies should allow investors to participate in gains if the market rallies, while offering a degree of capital protection in case markets fall further. Tilting exposure toward more defensive sectors, like global healthcare and consumer staples, which are likely to be less exposed to a deterioration in economic growth, can also help reduce downside risks while retaining upside exposure. Read more on our latest positioning advice in the?CIO Alert?"Managing heightened risks."

What to do with cash?

Cash has reclaimed its status as king this year, given the sharp declines in stocks and bonds. With the reset of interest rate expectations, the yields on bonds and cash alternatives have also improved dramatically, touching 4.5% on 2-year Treasuries last week. There are now some great opportunities to enhance your cash holdings without taking on much, if any, additional risk, which can help offset at least some of the impact that 8% inflation has on purchasing power.

With 1- to 3-year yields above 4%, bond and CD ladders are an attractive option for short-term liquidity needs and should form the core of a Liquidity strategy. These ladders generate income while immunizing the portfolio from future rate moves; the proceeds from maturing bonds align with cash flow, and current yields help preserve purchasing power. Current post-tax yields on one- to three-year investment grade corporate bond ladders is about 2.6%, just shy of market inflation expectations of 2.8% over the next three years. The ladders can also be structured using short-duration municipal bonds for added tax efficiency, which currently offer around 5% in tax-equivalent yields.

In addition, we recommend satellite strategies to tap into growth and yield opportunities in exchange for liquidity, credit, or counterparty risk. Bank deposit and sweep account yields have started to trend higher, providing a welcome raise for investments that keep your powder dry in highly liquid and safe investments for uncertain or emergency needs. For known near-term expenses, money market yields, which have started to rise in response to rate hikes, are attractive. For high-income investors, municipal bonds appear particularly attractive in the current market, with taxable equivalent yields at levels not seen in more than a decade. The yield curve remains sharply upward-sloping in the 1- to 3-year range but is inverted beyond that point.

For funds that can be safely locked away for longer, consider three- to five-year termed structured products linked to equity markets or commodities with full downside protection. These provide potential for growth that can help offset the impact of inflation. Read more in "Liquidity strategy: A rising tide lifts all yields."

Liquidity. Longevity. Legacy. disclaimer:?Timeframes may vary. Strategies are subject to individual client goals, objectives, and suitability. This approach is not a promise or guarantee that wealth, or any financial results, can or will be achieved.

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