The economic outlook is inherently uncertain, but recent years in particular have been marked by major global shocks, from the COVID-19 pandemic to the Russia-Ukraine war. This uncertainty has made it increasingly important to work with possibilities and probabilities, instead of relying on fixed forecasts. In such a volatile environment, central banks have found themselves navigating uncharted waters when it comes to inflation.
In the decade of 2010-2020, inflation in the United States remained below the target of 2%, despite aggressive easing measures adopted by the Fed. In response to this, the Fed introduced the Flexible Average Inflation Targeting (FAIT) framework in 2021. Previously, the Fed’s policy was to raise interest rates if inflation started at 2.0% and therefore inflation would not shoot above 2.0% in the most many circumstances. It was widely believed that this previous policy, although it kept prices relatively stable, resulted in lower employment growth.
The new FAIT framework now allows inflation to exceed the 2% target to offset previous undershooting and therefore the Fed will target inflation of 2.0% for a period of time. However, this turned out to be a policy mistake after COVID. Their belief that inflation would be temporary was rejected and to control high inflation, the Fed had to embark on one of the most aggressive tax hikes in four decades.
This has led to the current situation where the Fed funds rate has exceeded 5.25% and core inflation is still higher than the Fed’s projections last year. This has implications for both the real economy and financial markets.
While Fed rates have raised interest rates on credit card debt, auto loans and mortgages, the impact on consumers has so far been limited. This is mainly due to the structure of consumer debt, where the majority is in the form of fixed-rate mortgages. In addition, the resilient labor market has kept wages in line with inflation, allowing consumers to maintain their spending habits. As a result, personal consumption spending, which accounts for more than two-thirds of the US economy, remained robust.
Similarly, due to government policies such as the Inflation Reduction Act, CHIPs Act and the Bipartisan Infrastructure Act investment spending also continued. However, monetary policy operates with indefinite lags. More Americans are now behind on car loan and credit card payments than at any time in more than a decade. Home affordability has also suffered as the average 30-year fixed mortgage rate has risen to 8%, the highest level since 2000. Housing affordability has fallen by nearly half since the ultra-low interest rate days of 2021.
As the Fed continues to raise interest rates, US Treasuries, considered risk-free assets, are offering higher yields. This attracts global investors, leading to upward pressure on borrowing costs in other countries as well. At the same time, the US dollar appreciates against other currencies, which presents challenges for many emerging economies as they experience currency depreciation due to capital flight. This forces other central banks to raise interest rates to defend their currencies, often at the expense of local economic growth. Among developed markets, Japan provides an apt example of these challenges. It has been struggling to meet its inflation target for years. The Bank of Japan maintained an easy monetary policy, but this caused depreciation pressure on the Yen. A balancing act between monetary management and pursuing an independent monetary policy to address its internal inflation-growth dynamics has become difficult as the Fed has raised rates.
Given the changing economic landscape, investors should review their asset allocation. Rising interest rates have increased the appeal of bonds as a source of income, especially compared to equities. The equity risk premium is at its lowest level in the last two decades. For investors, this may warrant a shift to short-term bonds and floating rate instruments. Stock valuation multiples tend to correct when interest rates rise, especially for stocks dependent on cash flows far into the future. In this environment, value-based investing is preferred over growth-style investing within stocks.
Diversification is key for individuals seeking to protect themselves against uncertainty. Given the heightened geopolitical risk, gold can serve as a safe haven and store of value. When yields, especially real yields rise, gold tends to struggle. But the recent rise in UST 10-year yields is also due to concerns about US public debt. The yellow metal should find favor among such an environment.
In a market environment where various asset classes are facing increasing pressures, alternative investments are emerging as a valuable strategy for risk mitigation. This is particularly significant because, during market downturns, the correlation between stocks and fixed income tends to trend strongly into positive territory.
Private equity firms tend to get better investment deals during such periods as valuations begin to decline. Also, their long-term approach gives them better ammunition to ride on medium-term uncertainties.
On the listed side, utilizing equity long-short strategies that allow for potential returns without directly betting on market direction can prove to be a very effective approach. The recent technological advances in machine learning and artificial intelligence have created an edge for quant-driven investment strategies and they continue to outperform.
All market environments create opportunities and investors must wisely reallocate capital between asset classes. The current challenge of navigating high inflation and the Fed’s policy actions are no different.
This article is written by Mohit Ralhan, Chief Executive Officer, TIW Capital. All opinions expressed are personal.
