The Federal Reserve is set to begin rapid quantitative tightening just two months after quantitative easing. Faced with the effects of a worsening commodity shock, the US central bank is in danger of possibly over-correcting.
- The Fed has positioned policy to be pro-cyclical rather than countercyclical, likely adding to financial market and economic volatility. Therefore, we’ve cut our US real GDP forecast for 2022 from +3.5% to +1.9% By easing during a boom year in 2021 and being hawkish at present, the Fed is raising recession risk for 2023. We put the probability at 30% on the belief that the Fed has time to adjust its course while supply fundamentals recover. The Fed has rarely tightened into a supply shock which has no precedent for a monetary cure.
- After a -18% year-to-date return in long-duration US Treasuries, our Global Investment Committee has added an overweight for the first time since yields bottomed in 2020. Lagging indicators such as employment and inventory restocking provide inertia for economic growth to continue this year. However, a demand slowdown is inevitable. We’ve shifted 2% of medium-risk global portfolios into long-duration Treasuries and may make further upward adjustments. We also continue to hold an overweight in TIPS, at a reduced scale.
- The overall global Fixed Income weighting remains -3% as we retain large underweights in European and Japanese government bonds. However, long-term European sovereign yields may also stabilize or fall in the year ahead.
- Historically, the highest quality long-term government bonds are one of the few assets with a negative correlation to equities during large corrections. When US equities have dropped 20% or more during the past three decades, long-term US Treasury returns have averaged +12%. While a bear market is not our base case, along with a 2% overweight in gold, we have further shifted our asset allocation seeking to hedge downside risks.
Where next for equities?
- Our global equities allocation remains 2% overweight. However, excluding our 4% allocation to natural resources producers and oil services, the weighting is -2%. After briefly rising to $128 per barrel in early March, the crude oil price has fallen 23%. Nonetheless, most global commodities futures prices for the next two years have risen, signaling a rise in profits for natural resources producers at the expense of consumers. This is on the likelihood of prolonged supply disruptions from Russia/Ukraine.
- Very large releases of strategic oil reserves have helped stem the oil price spike, but as this is merely an inventory drawdown, oil futures measured over the remainder of the decade changed by only $0.10 per barrel on the news. The drop in oil will limit near-term inflation to less than we projected, with the US CPI likely to peak for the cycle near 8.5% year/year (and the Fed’s preferred inflation gauge well below this level). However, most other commodities do not have large and effective strategic reserves. The downstream effects of rising input costs will still impact many final products in time.
- The only true cure for commodity shortages is rising production. The upward tilt in futures curves suggests a potentially long holding period for our thematic investments in natural resources and oil services. This is the case even if commodity futures prices don’t rise.
- Our thematic investments in natural resources are, however, a special situation within cyclical industries. With growth likely to slow, and government bond yields likely to peak, we would not shun high-quality growth equities. We hold thematic overweights in pharmaceuticals, cybersecurity and fintech/payments shares. We hold the most consistent global dividend growth equities overweight, while underweight small cap shares. This is to emphasize balance sheet quality and profitability. Credit markets are firm but will likely come under increased stress later in the central bank policy tightening cycle.