Economic Insights for July 2022

The following are some economic insights for July 2022.  Headline inflation ticked up in most countries in May.  Central banks have been aggressively increasing their key interest rates to try to bring inflation under control.  A strong majority in the market expects the Federal Reserve to increase the magnitude of rate hikes, by perhaps, +75bps in the next meeting, to reach neutral levels as early as end-July (2.50%), and possibly a higher than neutral (3.75%) by end 2023.

The European Central Bank hinted at an increase in policy rates of about 200bp by the end of the year.  A broad tightening of monetary conditions, along with tighter fiscal policies, is fueling fears of recession within the next 12 to 18 months.  However, central banks’ policy stance will likely soften once policy rates reach restrictive territory, reducing the odds of a severe recession.

China’s economy showed further signs of improvement in June with a strong pickup in services and construction, as Covid outbreaks and restrictions were gradually eased.  Eased lockdown measures should support growth in the near term.  China remains an outlier in a world of surging inflation, with further selective policy easing - monetary and, more importantly, fiscal.

Asset allocation decision remains one of the largest drivers when determining the range of portfolio outcomes amid volatile markets.  Major central banks are aggressively tightening monetary policy, bond yields have increased sharply, and most asset prices are down.  With US Treasury yields at levels not seen in more than a decade and the potential increasing risk of a global recession, major funds have dialed down equities to a small underweight with a moderate allocation to cash to serve as dry powder.

It is expected that most funds will  reduce equities to a small underweight after a sharp rise in US Federal Reserve interest rate and an increased risk of US recession.  Earnings expectations will likely decline due to higher inflationary pressures.  Valuations are also unlikely to rise into an economic slowdown.

Regarding equities, across markets, it is advised to maintain a moderate overweight to Asia ex-Japan equities, primarily driven by the relatively positive outlook in China.  The region remains at attractive valuations, even after its recent rise.

Regarding investment grade credit, credit spreads have widened meaningfully year to date.  However, against their own histories, spread moves remain relatively modest given the default and downgrade cycles have been gentle.  It is preferable to have shorter duration in order to prepare for further hawkish surprises from the Federal Reserve.  It is also advisable to retain preference for Asian credit over US credit as the Asia ex-Japan spreads should be more resilient despite the decline in spread premium over the US. 

Regarding Treasuries, the Federal Reserve’s pivot towards aggressively fighting inflation has caused bond yields to increase sharply.  Short rates have been moving upward more quickly than the long end, causing the yield curve to flatten materially even though economic fundamentals remain robust in the near term.  It is expected that higher rates volatility and weaker price performance to continue over the medium horizon.