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Weekly Investment Commentary: What’s scarier: central banks or inflation?
Bottom line up top:
- Halloween Ends,” but the U.S. Federal Reserve’s outsized rate hikes keep producing sequels, despite poor reviews from the markets. Projections call for a 75 basis points hike in the fed funds rate at this week’s meeting, another +75 bps in December and +25 bps in February 2023, which would bring the target rate to between 4.75% and 5.00%. As Chair Jerome Powell has made clear, the Fed wants to see positive real rates across the entire yield curve. Real rates are already positive when measured by TIPS yields (nominal yields minus inflation expectations), so the additional tightening in store over the next few months could go beyond what’s necessary to tame the inflation monster, even if it’s not enough to persuade the Fed to hit the brakes.
- Like the Fed, non-U.S. central banks generally fear inflation more than the reaper — for now. Despite the specter of recession, most are pursuing hawkish policies that have driven market volatility. (The Bank of Japan, with its unique “yield curve control” policy, is the notable exception.) Whether the banks can or will stick by their guns as determinedly as the Fed is an open question. In fact, members of our Global Investment Committee recently offered varied projections on which central bank will be the first to reverse course from its current policy (Figure 1) as the recessionary impacts become clear. On balance, our GIC leans toward the view that non-U.S. central banks will be under more pressure than the Fed to make a U-turn. We asked Anupam Damani, Nuveen’s Head of International and Emerging Markets Debt, for insights into the complex challenges these central banks face. She and her team offered these perspectives:
European Central Bank: The ECB, which hiked rates by 75 bps last week, with another 50 bps expected in December, is battling widespread inflation while simultaneously confronting a looming energy crisis. The impact of tightening will likely feed through to the region’s economies in the coming months, as sentiment indicators are weak and purchasing managers’ indexes are falling. After December, we expect the ECB to continue hiking, but at a slower pace of 25 bps per meeting, toward a terminal rate of 2.50% to 3.00% in the first half of 2023. At the same time, we anticipate the ECB’s balance sheet will begin to wind down in the form of passive quantitative tightening.
Bank of England: The BoE has been raising its base rate amid a daunting mix of political, fiscal and economic challenges. While recent fiscal policy changes may have created a less negative outlook regarding debt sustainability issues, the combination of higher rates and fiscal austerity will likely weigh heavily on the economy. We foresee a U.K. recession lasting from 3Q 2022 to 2Q 2023 followed by only tepid improvement into mid-2024. In terms of BoE tightening, a peak in the base rate is difficult to predict, but we anticipate it will reach 4.5% to 5.0% in mid-2023.
Bank of Japan: The BoJ delivered no surprises at last week’s policy meeting and remains the lone dovish outlier among developed market central banks. But swimming against the current has come with a heavy cost: extreme weakness in the yen, resulting in BoJ intervention to prop up the currency along with emergency bond buying. Meanwhile, inflation at 3% is high by Japanese standards and faces upward pressure. We think a recalibration of BoJ monetary policy is inevitable. An abrupt shift from the bank’s yield curve control program, established in 2016, is unlikely any time soon, as it might prove a shock to the system. Still, a policy tweak could happen as early as later this year, or sometime next year, before or after BoJ governor Haruhiko Kuroda’s term ends.
“We prefer high quality U.K. and European corporate bonds over Japanese government bonds, U.K. gilts and European government bonds.”
- Anupam Damani, Head of International and Emerging Markets Debt
Portfolio considerations
A cash conundrum. Immutable central bank policy has dampened investor enthusiasm across many markets and asset classes. Given this year’s near-universal negative investment returns, some investors are asking why they shouldn’t simply put their money in cash, which — thanks to the very hawkish monetary policies that have pummeled equity and fixed income markets — is paying attractive yields. The slightly positive expected real yield (assuming inflation does in fact fall in the next 12 months) on ultra-short-term U.S. Treasuries may be enticing for investors with cash to invest (Figure 2). But for most investors we work with, earning ~1% real yield before fees and taxes on a large portion of their assets is not a sustainable strategy.
“We understand why some investors may think moving into cash would be compelling, but doing so could well be a mistake.”
We think a diversified fixed income approach should still win the day.Today, investors can lock in a 6% tax-equivalent nominal yield on a diversified portfolio of T-bills, high quality municipals, core fixed income and BB-rated corporate bonds (a 2% premium over the 4% that can be earned in T-bills alone). There is no crystal ball to tell us when inflation will recede and central banks will change course. But historically, when this diversified portfolio has had a starting yield spread of 2% or greater than owning T-bills, the probability of outperformance over the next 12 months has been greater (Figure 3).
Nuveen’s Global Investment Committee (GIC) brings together the most senior investors from across our platform of core and specialist capabilities, including all public and private markets.
Regular meetings of the GIC lead to published outlooks that offer:
- macro and asset class views that gain consensus among our investors
- insights from thematic “deep dive” discussions by the GIC and guest experts (markets, risk, geopolitics, demographics, etc.)
- guidance on how to turn our insights into action via regular commentary and communications
Endnotes
Sources
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