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There is absolutely nothing straightforward about the current economic and financial environment. Soaring inflation is pushing central banks to raise policy interest rates sharply to cool the economy, with a particular focus on inflation. However, there is always a lag in the way this works. Western central banks in particular have waited too long with their response to rising prices. That also explains why emerging markets, on average, are outperforming in 2022. In the West, we might call this a reset. Zero interest rates (in the US) and negative policy rates in the Eurozone in 2021 are set to rapidly give way to higher interest rates.
The financial markets are looking ahead and anticipating the central banks’ next moves. Policy interest rates that have already been factored into bond prices today paint the following picture: a 5.0% policy interest rate in March 2023 for the US and a 2.9% deposit rate in June 2023 for the ECB. This means that the markets are assuming that central banks will continue to pursue restrictive policies in an effort to control inflation. However, this will likely also result in a deceleration of economic growth and in weaker corporate profits, which further complicates the investment climate. On the one hand, bond prices are falling because interest rates are rising and, on the other hand, equities are more vulnerable because of the slowdown in growth.
In this inflationary environment, unheard of for years, cash denominated in strong currencies and commodities in particular are holding up moderately well. Bond investors are currently better off with inflation-linked bonds, although a great deal has already been priced into this asset class. On the equity side, value stocks are typically holding up better. Stocks that have the potential for strong future growth are being ruthlessly punished in this environment. Any investors who followed these rules of thumb from the start of 2022 would probably not have performed that poorly. But hindsight is 20/20.
What can investors expect from the rest of the year and the start of 2023? Good quality corporate bonds and even some more speculative corporate bonds (provided they are short-term bonds with a maturity of 2, maximum 3 years) could offer some upside. Current interest rates for investment-grade corporate bonds are 4.5% and 6% for euro-denominated speculative corporate bonds when we consider the broad market for these instruments. Bonds from emerging countries also show potential. Current interest rates are over 8%, but since they are expressed in local currency, the exchange rate risk has to be added in. As the last category, US government bonds also warrant a place in a portfolio.
On the equity side, US companies that pay out an above-average dividend yield tend to be somewhat more defensive than shares of companies pursuing (very) strong growth. Similarly, although inflation is likely to decline in 2023, it will probably remain above average for the next few years. In the short term, then, it does not seem optimal to fall back on prescriptions that have worked well in recent years, such as investment in the technology sector. Instead, the focus in the future will tend to be on slowly building income on both the bond and equity sides.
Lastly, cash holdings could come in handy. Geopolitical risks remain high and major global changes are looming: climate, the war in Ukraine, economic warfare between the US and China, and tension between OPEC+ and the US. This is not exactly an ideal environment for major risks.
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