Interview with ‘El Economista’

1. Has the bond market, after the sell-off, reached a level of yields to maturity that is attractive enough to move back into bonds?

We are using selloffs in bonds as an opportunity to increase exposure to fixed income. While we have not necessarily seen the peak in yields, several areas of the fixed income market are now attractive enough to begin adding back duration.

2. Which kind of bonds do you find most interesting?

US and European investment grade bonds are increasingly attractive. All-in yields are much more compelling than they were in the last cycle, and provide some compensation for taking on recession risk or the possibility of prolonged central bank tightening.

3. Do you expect the equity declines to deepen much further?

We expect equities to be volatile, but rangebound. The US Federal Reserve wants to see financial conditions tighten, and effectively caps the upside on how high valuations can go (if they get too high, the Fed is likely to hint that the terminal policy rate is likely to be higher). On the other hand, US economic resilience due to the continued solid increases in nominal labor income, coupled with extremely depressed sentiment/positioning in equities, limits the potential downside in the near-term, in our view.

4. Do you see a change over the coming months in the outlook for corporate earnings growth for S&P 500 companies? Could estimates start to fall?

12-month forward earnings expectations for the MSCI World Index have been trending lower for the past few months, particularly when stripping out commodity-linked sectors (energy and materials) from the rest. Given the retrenchment in the global goods sector and strong dollar, earnings estimates should continue to come under pressure, in our view.

5. Do you expect the increase in funding costs due to central bank rate hikes to lead to falls in equity prices?

We anticipate that central bank tightening will continue to cap the upside in equities, both by making equity valuations overly stretched relative to bonds and also bringing about a slowing in economic activity that puts downward pressure on earnings estimates.

6. Is there a currency strategy that you think is interesting at the moment?

We maintain a positive US dollar bias. Two of the most disruptive developments for risk assets, in our view, would be either a global recession or a longer-lasting, more aggressive tightening campaign from the Federal Reserve. Either of these outcomes would likely be supportive of further dollar strength. While we acknowledge that the US dollar remains expensive, there are historical examples of even more pronounced deviations from fair value.

7. Commodities have been in a downward trend across the board since May, is this the first sign that we will see a decline in inflation rates in the near future, and what is your outlook for these assets?

The downdraft in commodity prices, particularly crude oil and gasoline, has already contributed to a moderation in the annual rate of headline inflation.

We find the risk-reward of investing in commodities and commodity-linked assets to be attractive. The downside in commodities is limited relative to past cycles because of the tightness of supply across most of these assets, in our view. Moreover, exposure to commodities remains very attractive from an asset allocation perspective in an environment of elevated inflation that may cause the stock/bond correlation to stay positive for a prolonged period. Since 1989, in months when global stocks and long-term US bonds both suffered meaningful declines, commodities have tended to outperform the traditional 60/40 portfolio by more than 3 percentage points.

8. When do you expect inflation to peak?

In the US, headline and core inflation have likely peaked. We expect both will face further downward pressure over the coming months as gasoline prices have fallen and supply chains are healing. Still, given the tightness of the US labor market, core services inflation should remain elevated for the next several months before eventually cooling in response to Fed hikes.

In the UK and Europe, measures to insulate households from the magnitude of the move higher in energy are also likely to create a top in realized consumer price inflation in the very near term.

9. What level do you expect interest rates in the US to peak at? And in Europe?

We expect the US policy rate to peak around 5 to 5.5%. There remain upside risks to this forecast as growth and inflation may surprise to the upside. For the European Central Bank, we expect rates to peak in a range of 2.5 to 3%.

10. Once rates peak, do you expect central banks to be forced to reverse their policies and begin a process of lowering rates because of the economic damage being done, or will rates stay high for a while?

We believe central banks will be reluctant to reverse on rate hikes because many are worried about inflation expectations becoming unanchored to the upside. From their perspective, a recession is preferable to scenarios in which consumers no longer trust them to sustainably deliver on their inflation mandates. Just as central banks were behind the curve in tightening policy, we believe they will also be behind the curve in providing accommodation.

11. Following China’s 20th Communist Party Congress, do you expect any major changes to that could affect investments in Chinese or Asian companies?

Our view on China is one of tempered optimism. We think that policy stimulus will be sufficient to alleviate concerns about a hard landing in the real estate sector, cushioning domestic assets and commodities. However, we also expect that the Chinese expansion will remain on fragile ground for as long as zero-COVID policies are maintained. Recent guidance for reopening next year is encouraging, though there is plenty of uncertainty on just how much we will see a removal of restrictions. Given attractive valuations, even some movement in a more supportive economic direction should boost the attractiveness of Chinese and broader Asian equities.

12. Geopolitics is becoming increasingly important for the markets. Do you think this will continue? Are there any major events in the coming months that you think could generate volatility in the markets (elections, etc.)?

Geopolitical developments are likely to continue to be a potent market force, in part because investors who were wrong-footed by Russia’s invasion will be wary of making a similar mistake again.

Potential events that could catalyze volatility (to either the upside or downside):

• If the Federal Reserve were to increase the size of rate hikes, due to stubbornly high inflation and a still very tight labor market.
• An escalation in hostilities or détente between Russia and Ukraine
• Upside or downsides surprises in China’s path towards reopening.
• The Bank of Japan– additional upward pressure on global yields and weakness in the yen could bring about an end to the longstanding yield curve control policy