Until the job is done

A year ago, interest rate hikes by the Federal Reserve (Fed), the European Central Bank (ECB), the Bank of England (BoE) or the Swiss National Bank (SNB) in increments of 50-100 basis points would have been hard to imagine. Looking ahead to the final quarter of 2022, it now almost seems as if central banks are competing to see who can raise interest rates faster and more aggressively in order to combat record high inflation. After Federal Reserve Chairman Jerome Powell missed his “Draghi moment” at the last monetary policy (FOMC) meeting – we recall the former ECB president's legendary statement during the euro crisis, “whatever it takes” – most (at least Western) central banks have now taken the no-strings-attached fight against inflation to their banners. The decisive factor here is that the monetary authorities in Washington, Frankfurt and London are now prepared to accept more than just collateral damage. In some regions, the rapid tightening of interest rates will almost inevitably lead to a recession. The consequence for investors is that neither the Fed nor the European central bank can be expected to weaken their hawkish stance in the foreseeable future.?

Not yet restrictive enough

All Western central banks are now in the fight against the highest inflation rates in about 40 years. The focus, however, will be on the Fed, which has clearly communicated that current financing conditions are not yet restrictive enough. As shown in our first graph, financing conditions have risen sharply in recent months, but at 100.5 points the index is only at its historical average (40 years).

Most of this increase is due to the weaker equity markets on the one hand and the rise in long interest rates on the other. Capital markets now expect US interest rates at the short end to be raised to 4.5-5.0% in the first quarter of 2023. In addition, the Fed is attempting to become even more restrictive by reducing its balance sheet (quantitative tightening). The environment is also becoming more and more challenging for companies, as banks are increasingly restricting lending. Our credit cycle indicator has now reached its lowest level in ten years.?

Increasing risk of monetary policy errors

There are many reasons why inflation in the Western world is so high now. One decisive factor are the fiscal packages in the second phase of the corona pandemic, which in retrospect would probably not have been necessary to this extent. For the last quarter of 2022, the risk has increased for central banks to commit a classic policy error by aggressively raising interest rates or reducing their balance sheets. The effect of rate hikes typically has a lag of six to nine months. The Fed made its first rate move of 25 basis points in March 2022. Overall, we believe the likelihood of a recession or at least an economic downturn has increased not just in the United States.?

Macroeconomic environment

The macroeconomic environment has recently deteriorated further, also due to increasing turbulences on foreign exchange markets (e.g. euro, pound and the yen all dropped to record lows against the US dollar) and in the political arena (Italy). Forecasts are now below potential growth for the whole of 2023. For example, the Fed anticipates economic growth of 1.2% next year (potential growth 1.8-2.0%) and raised its inflation forecast for the current and next year. According to the Fed, the US core inflation rate will be 4.5% this year and 3.1% in 2023, which is well above the Fed’s 2% target. The growth-inflation mix has thus deteriorated. We can observe a similar situation in Europe, although the energy crisis is a different inflation driver than in the US. We note that the probability of recession has increased on both sides of the Atlantic.?

Investment strategy - Defensive positioning in all asset classes?

Since the beginning of this year, we have recommended not to buy setbacks on the stock markets (buy the dip). Despite the recent correction, we believe that it is still too early to build up risks in the current environment. Risky assets have received competition across assets recently. For example, investors can now invest in a two-year US Treasury bond yielding over 4%, making the “TINA” mantra (There Is No Alternative) a thing of the past. We think that as long as real yields are rising and investors anticipate further central bank rate hikes, a defensive positioning in all asset classes makes sense.

Equity strategy

Global equity markets remain under pressure as the likelihood of a soft landing has diminished. Central banks will have to fight inflation with all consequences, including a recession. By historical standards, the price-to-earnings (PE) ratio of the MSCI World is now at its 30-year average. However, the big unknown remains the earnings outlook for companies in the next few quarters. In our view, analysts' earnings estimates continue to be too optimistic. Therefore, we remain defensively positioned within the equity allocation and do not yet see the time to increase risk. The upcoming reporting season should provide information on how strong the decline in earnings will be in the coming quarters. At sector level, our preference remains for pharma and telecoms over technology and consumer cyclicals.

Fixed income strategy

Given the current communication and direction of monetary policy, an overshooting of interest rates cannot be ruled out. We maintain our neutral duration positioning but see increased attractiveness in individual segments (US government bonds). In addition to patience, timing is also crucial. Due to the changed macroeconomic environment and the increased danger of a worldwide recession, we reduce the risk and thus downgrade the high-yield segment to unattractive.

Gold

Gold has come under pressure in the last month from a strong US dollar and rising real yields. Despite short-term uncertainty regarding those two drivers, we still like gold as a strategic diversifier to protect basic portfolios.?