Navigating Rising Rates, War and Inflation

• Yields Jump and Bonds Lose as Fed Tightens
• Supply Shocks Still Unfolding with War
• Europe, China Feel Economic Pain
• Favoring U.S. Equities, Natural Resources and High Yield Bonds

Transcript

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After the worst performance in the bond market in decades, investors are concerned about the path of interest rates and the eventual impact on growth. How should investors position for the environment that might unfold? Let's take a closer look.

The US bond market just exited its worst quarter in years, as a jump in the 10 year Treasury yield from 1 and 1/2 to 2 and 3/4 percent led to noticeable losses across virtually all bonds. The Federal Reserve entered this year only expecting to hike rates three times, but the persistence of high inflation is now with the market to price in a Fed funds rate over 2% by year end.

Central banks seek to tighten financial conditions to slow growth, and therefore hopefully inflation. For example, the jump in the 30 year mortgage rate from 3.25% at the start of the year to 5% should lead to some eventual cooling in housing prices.

Unfortunately, the war in Ukraine remains a core risk as the humanitarian crisis continues and signs of war atrocities are rising. This is only increasing the resolve of the West, which boosts momentum for further Russian sanctions. Major supply shocks are in some respects still to unfold.

But as shown by the 20% rise in wheat prices since February 23rd, markets are reflecting the perceived eventual impacts. Further military escalation remains a risk case, with the potential for the use of unconventional weapons or further geographic incursions. Our base case scenario envisions a long drawn out affair without clear resolution.

In the wake of persistent inflation, the Ukraine war, and lingering COVID-19 problems global growth is slowing. Europe is at risk of recession, and China is suffering from the effects of COVID-related shutdowns. US growth is holding up relatively better, and nominal growth in the second quarter could hit 10%. A risk case for us is the global slowdown leaking into the US, leading to disappointing growth.

Nevertheless, US growth looks better insulated than Europe or China, and we resulting favor US equities over Developed ex US and emerging market stocks. We also continue to favor natural resource equities, which have provided significant benefit to portfolios this year, because of commodity shortages and inflation concerns.

Finally, we continue to like high yield bonds, due to their attractive yield and strong fundamentals. The sharp tightening of credit spreads over the last month should give some comfort to those worried that an inversion of the yield curve is a certain sign about impending recession.