Economic Insights for November 2022

The following are some economic insights for the month of November.  As of now, global economic activity is experiencing sharp growth slowdowns.  Inflation is higher than we have seen in several decades.  We have to consider that the ongoing conflict in Ukraine, supply chain disruptions, and the lingering effects of the COVID19 pandemic all point to a negative outlook.  As such, most economists have lowered their forecasts for GDP growth in 2022 and 2023, and have raised the forecasts for inflation. 

The Federal Reserve and most central banks in advanced economies are expected to maintain a restrictive policy stance. As expected, the Federal Reserve hiked up interest rates by another 75 bps to reach 3.75%.  There is an apparent commitment to raise the rate to about 4.50% to 4.75% by end of Q1 2023.  This range is well above the neutral rate.  The prolonged hawkish stance of central banks has triggered increasing fear of recession, which is overblown.  This, of course, benefits the US dollar, which is viewed as a safe haven asset. 

On the other hand, People’s Bank of China is far from hiking rates amid the weak economic momentum.  The Chinese Communist Party is not going to risk an economic slowdown, and would rather ride out the inflation.  However, the increasing rates differential versus the US has forced the central bank to pause monetary easing and keep the key rates unchanged.  China’s economy has rebounded in Q3 but any strong recovery in the long term will be challenged by its property crisis, strict zero-Covid controls and lockdowns, the threat of corporate bond default, and global recession risks. 

When determining the range of portfolio outcomes amid volatile markets, asset allocation decision remains one of the largest drivers.  We are now in an environment of fast-paced central bank rate hikes, rising risk of recession, and potential rising unemployment across large developed markets.  Growth is unlikely to bounce back quickly in the absence of central bank easing.  In such a case, it is recommended to stay underweight equities, cautious on bonds with preference for lower durations, and set aside increasing allocation to cash.  This liquidity is prudent since it allows to make opportunistic purchases when valuations inevitably drop to attractive levels. 

It is recommended to continue staying underweight for equities to mitigate downside risk.  Weaker macro conditions and a higher risk premium means expected equity returns remain low.  The driver to lowering markets is valuation derating.  It is also recommended to maintain a neutral view towards Asia excluding-Japan equities.  The overall outlook remains uncertain due to local central banks turning hawkish amid multiple external headwinds.  China is an exception. 

It is prudent to remain cautious on credit especially, high yield credit as it is expected that yields will further widen amid economic slowdown and worsening corporate results.  The preference is short-maturity credit as they are less sensitive to interest rate changes.  The rise of interest rates increases the borrowing costs.  This affects revenue, which in turn impacts corporate profits. 

The aggressive Federal Reserve policy tightening in the face of stubbornly high inflation has caused bond yields to increase sharply.  As such, short rates have been moving upward more quickly than the long end, causing the yield curve to flatten materially.  We should expect higher rates volatility and weaker price performance to continue over the medium horizon.