Higher for longer, but not forever

THE business of economic forecasting and investment strategy just got more difficult.

With the ubiquity of news and market and economic indicators, every investor feels empowered with the knowledge to forecast economic growth and asset return profiles. That confidence also arises from the oft-mentioned conviction that stock markets anticipate the economy with a six to nine-month lead time.

The 2022 stock market sell-off prompted investors and analysts to ring the dreaded “recession bell” in a concerted manner. According to a Google Trends search, the term “recession” spiked in June 2022 following an S&P 500 sell-off that began from the start of last year.

A year on, reality got in the way. We are nowhere near the hyperbolic scenarios predicted by the equity markets in 2022, although global growth is indeed slowing.

Looking through decades of data on stock markets and gross domestic product, it is true that stock markets always decline before recessions. However, there were also many periods where stock markets entered bearish territories without tanking economies.

In fact, when the S&P 500 posted a remarkable year-to-date gain of nearly 20 per cent in August this year, investors and analysts were again quick to call for an economic soft landing. A Google Trends search correspondingly showed a spike globally in the term “soft-landing” in the same month that the S&P 500 hit a high.

So, what is the real situation? Where are we now on the business cycle?

We think that the US and many developed economies are not in a recession now, but are late into the current business cycle.

Since early 2022, the US Federal Reserve has embarked on aggressive rate hikes alongside balance sheet reductions to combat stubbornly high inflation. The good news is that price pressures in the US have started to moderate from the second half of last year.

In fact, core goods inflation has decelerated the most as supply chain pressures eased, with shelter inflation starting to level off in recent months as well. With both job quits and vacancy rates falling rapidly from their all-time peaks, the implication is that the US labour market is weakening marginally.

Furthermore, wage growth has begun to slow, though further deceleration is likely needed to be consistent with the Fed’s 2 per cent inflation target.

Additionally, as interest rates remain high and the US economy slows down, Fed data shows that more Americans, especially the young (18-29 years old), are struggling with debt. One can argue that higher debt burdens may not necessarily dent consumption as US households have built up substantial excess savings during the pandemic, peaking at more than US$2.3 trillion in 2021.

However, savings started heading south from the fourth quarter that same year and is currently sitting at less than 40 per cent of its value two years ago. Despite rising incomes, personal consumption expenditure is a significant drag – and Americans are making up the difference by running down their savings.

With the prospect of an economic slowdown, we think that the Fed is likely to be at the end of its hiking cycle. Despite Fed members’ warnings that interest rates must remain “higher for longer ” during the Federal Open Market Committee meeting in September, Fed chair Jerome Powell did hint that he may be considering some latitude, saying that the “Fed can now proceed carefully”. We take this as “higher for longer, but not forever”.

UOB expects one more 25 basis point hike during the Fed’s November meeting, with rates likely to remain at this “terminal” level until the end of the first half of 2024. We would advise investors to gird themselves for a recession despite the Fed’s continued assurances of a “soft landing”, as there is no smoke without a fire. Economic observers have noticed time and time again that recessions are usually “man-made” (read: central bankers), and we believe it is no different this time.

What does this mean for investment portfolios?

The inevitable slowdown of the US economy suggests that prospective risk-adjusted returns for bonds are attractive. Investors should use the current elevated long-term rates to build positions in high-quality bonds, as these assets will prove useful in a declining growth environment amid peaking Fed policy rates.

In April this year, Pimco fund managers conducted a historical analysis of asset class returns under various Fed policy and US growth scenarios since 1950. They found that if the Fed pauses at its peak rate for at least six months and the US slides into recession, the 12-month returns following the final rate hike could be flat for 10-year US Treasuries, while the S&P 500 could sell off sharply.

On the other hand, if the Fed pivots more quickly and cuts rates within six months of its last hike, equities could rally in the 12 months following the final rate hike – but bonds would still outperform equities.

For now, our base case scenario is for the Fed to pause at peak rate following the expected 25 basis point hike in November this year, until the end of the first half of 2024. This means that portfolios should increase exposure to fixed income such as government bonds and investment-grade corporate bonds.

However, with fixed deposits (FDs) currently providing respectable returns, many investors often ask: why invest in bonds when FDs have similar or even higher yields at lower risk?

If only investing were so simple.

In a late economic cycle, it is important to note that interest rates will eventually be cut, and FDs’ relatively high rates today may not be sustained when they mature.

In addition, there are several advantages to incorporating bonds into a portfolio.

First, investment in bonds provides a regular stream of income in the form of coupons, whereas FDs are held to maturity when the saver receives the principal and interest return.

Second, investors often forget about reinvestment risk, which matters when duration of FDs are often shorter than that of fixed income. Especially when the markets expect lower interest rates in 2024, monies from matured FDs could potentially be placed in new FD tranches at lower rates.

Third, bond investors not only collect coupons during the life of the bond, but bonds are also liquid and can be sold in the secondary market if the investor requires funds urgently. Withdrawing an FD before maturity forgoes the total interest earned.

Fourth, in the event of a Fed pivot (rate cut), investors can potentially enjoy capital gains as bond prices spike due to the rush to safe havens. There is no price upside in an FD account.

In a world of slowing economic growth, tighter financial conditions, rising inflation and heightened geopolitical tensions, selectivity is key. Investors should focus on higher-quality companies in equity and debt markets, whose business models can withstand the road bumps.

The months leading into 2024 will likely show the success of central banks in bringing down inflation. Despite recent forecasts by central bankers and investors that we may be heading for a soft landing, it is always prudent to prepare for any possible downside. Investors can consider retaining exposure to assets that provide diversification during flight-to-quality events, such as longer-duration bonds, and serve as dry powder to capitalise on dislocations, such as cash.

An analogy is the use of life insurance for protection. We will never be able to forecast our future life and health conditions, but we need to have adequate protection to respond to any eventuality. Similarly, fixed income instruments are akin to insurance for portfolios, in the event we are stricken by recession.

This late-cycle investment playbook also requires careful portfolio construction and the ability to stay nimble as risks and opportunities evolve.

The writer is investment strategist, UOB