Navigating the Descent from Peak Rates

After three years of elevated inflation, the long-awaited interest rate cutting cycle has finally commenced. Central banks, having accumulated enough confidence that inflation is on a sustainable path towards their targets, are beginning to reduce monetary restrictions. 

Despite lingering high services inflation in some regions, the combination of lower inflation and still attractive government bond valuations is likely to bolster bond markets in the latter half of the year. 

As we transition to the next stage of the monetary cycle, we outline three key investment convictions.

1. Braking Downhill: US & UK Rate Cuts

Imagine driving a car downhill. As you descend, you need to find the right balance with the brakes. If you brake too hard, you risk skidding, but if you do not brake at all, you might lose control. 

This analogy reflects the current situation with inflation in the US and UK. While energy, food, and goods inflation have normalized, services and housing inflation remain elevated. This persistence can largely be attributed to very tight labor markets, which have driven up wages and aggregate demand. 

With restrictive monetary policies in place in both the UK and the US, we believe the imbalances in labor markets are gradually diminishing, akin to applying gentle brakes. For instance, the ratio of job vacancies to unemployed individuals, a key measure of labor market slack, has decreased significantly, returning to pre-COVID levels. The gradual easing of labor market tightness should help further reduce aggregate demand and services inflation, like controlling a vehicle’s speed.

Despite these developments, the Federal Reserve and the Bank of England (BoE) however, are cautious about a resurgence in inflation and have thus far resisted cutting interest rates. By delaying rate cuts, they risk causing more harm to labor markets and may eventually need to cut rates more aggressively to support economic growth. Consequently, we continue to see value in global government bonds, particularly US Treasuries and UK Gilts, as a prudent investment strategy like using brakes wisely to ensure a safe descent.

2. Tending the Garden: Ending Excessive Money Supply

Think of the economy like a garden. During the pandemic, central banks flooded it with water (money supply) to ensure growth, much like overwatering plants to help them thrive. Now, we must ensure to avoid drowning the plants. The recent surge in inflation was significantly driven by an increased money supply during the pandemic, especially in developed countries.

We are approaching a point where the excess inflationary monetary stock in the US will disappear, likely by the end of this year. At that juncture, monetary policy should shift to a neutral stance, allowing nominal economic growth without hindrance, much like providing the garden with just the right amount of water. Given that monetary policy operates with long and variable lags, there is a risk that the money supply will not return to trend quickly once the excess is removed. 

This scenario presents a monetarist argument for below-target inflation, as the money supply would decrease relative to the economy's size. Should this occur, the Fed might implement significant interest rate cuts to stimulate lending and money growth, which would support government bonds as yields decline – ensuring the garden flourishes with optimal watering.

3. Treasure Hunt: Selective Value in Credit Markets

Consider a treasure hunt. Initially, high-yield bonds were the obvious treasures, but as more hunters arrived, the easy pickings were taken. Since the beginning of the year, we have been reducing our high yield exposure, primarily due to valuation concerns. Spreads have tightened considerably, making the risk/reward balance for high yield investments less attractive – fewer treasures in an overhunted area. 

In the meantime, we see value in investment grade corporate bonds, particularly in EUR and GBP markets – hidden gems. Corporate bond spreads in Europe remain wide compared to historical lows, whereas US spreads are still near their tightest levels in the last decade.

We also find value in GBP investment grade credit. The Bank of England has actively sold its entire corporate bond portfolio acquired during the COVID crisis, effectively putting downward pressure on prices. Now that this indiscriminate seller has exited the market, Sterling credit prospects could improve  moving forward, uncovering a new trove of treasures.

As we navigate the descent from peak interest rates, our investment strategy is guided by the evolving landscape of inflation, labor market dynamics, and credit market valuations. By understanding these key factors and their implications, investors can better position themselves to capitalize on emerging opportunities. The road ahead may be complex, but with informed strategies, it is possible to traverse this shifting monetary terrain successfully, much like navigating a challenging journey with the right tools and knowledge.
 

*This article was first published, in Chinese, in the Hong Kong Economic Journal.

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. The views expressed in this document should not be taken as a recommendation, advice or forecast. Past performance is not a guide to future performance.