4Q Outlook: Higher Rates for Longer: What Does it Mean for Markets?

Fourth Quarter 2022 | By Nanette Abuhoff Jacobson and Supriya Menon Global Investment Strategy Global Macro Analysis International Volatility Equity

For central banks the inflation fight is on, but policy and market responses will vary in the coming months.

What You Need To Know

Expect weaker growth ahead. Central banks will be fighting inflation and slowing growth with varying regional impacts. Higher rates, tighter liquidity, and weaker financial conditions suggest downside risk to earnings and multiples, leaving us preferring a moderate underweight to global equities vs. defensive fixed income.
Within equities, we think fundamentals favor the US and Japan over Europe and emerging markets (EM), both of which may feel the effects of high energy prices and weakness in China more acutely. US-dollar (USD) strength is pressuring EM inflation and current-account deficits higher.
We favor a slight overweight to defensive fixed income, balancing the tug of inflation against elevated recession risks. Valuations and central-bank hawkishness suggest a long US-rate posture vs. short European rates. Spread¹ valuations aren’t especially attractive and appear vulnerable to risk aversion.
We maintain our moderately overweight view on commodities, though differentiation is required. China’s COVID-19 restrictions and property-market problems leave us favoring energy over industrial metals. Gold remains vulnerable to higher US real rates.
Downside risks to our views include a severe recession in the US or Europe, a currency-induced sovereign crisis, and an escalation in the Ukraine conflict. Upside risks include a soft-landing scenario—in which the Fed tightens policy just enough—and significant policy intervention in China.

The equity rally in July and August seems like a distant memory, with market optimism having been wiped out by higher inflation readings, more central-bank tightening, another natural-gas supply shock, continued weakness in China, and corporate-earnings warnings. In addition, divergent monetary and fiscal policies—highlighted by the UK’s initially conflicting signals—are driving market volatility and dislocations.

On balance, we see tighter monetary policy and the risk of lower corporate earnings and multiples weighing on risk assets² over the next few months. But in this environment, the risk/return profile of assets can change dramatically, and we’re on the lookout for prices being driven down by factors other than fundamentals. Among the signals we will be watching for in order to assess whether it’s time to add risk: Is the market pricing in a severe recession, and is the economy sufficiently weak or inflation sufficiently contained to trigger a pause in Federal Reserve (Fed) tightening?

Our regional views have changed somewhat, as higher inflation is being met with asynchronous central-bank, cycle, and market reactions. Within our moderately underweight view on global equities, we continue to prefer the US and Japan but are more negative on European equities. The US is supported by consumer spending and balance-sheet health, while a European recession due to the energy-supply shock seems inevitable.

Turning to bond markets, we were early in calling a shift in market sentiment from stagflation to weaker growth last quarter but continue to think weaker growth is coming and with it, stabilizing bond yields. Here, too, we’re differentiating between US and European markets, with the Fed ahead of the European Central Bank (ECB) in its inflation fight (FIGURE 1). Within our neutral overall global-rates view, we favor being long US rates and short European rates.

FIGURE 1

Higher for Longer Looks Priced Into US Rates Market
Fed funds futures implied overnight rate, post 7/27/22 and 9/21/22 Fed meetings (%)

As of 9/27/22. Actual results may differ from expectations. The federal funds rate is the target interest rate set by the Federal Open Market Committee. This target is the rate at which commercial banks borrow and lend their excess reserves to each other overnight. Source: Bloomberg, chart data: 9/23/22-1/31/24.

Our Multi-Asset Views

OW = overweight, UW = underweight
Views have a 6–12 month horizon and are those of the authors and Wellington’s Investment Strategy Team. Views are as of 9/30/22, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may make different investment decisions for different clients. This material is not intended to constitute investment advice or an offer to sell, or the solicitation of an offer to purchase shares or other securities.

We retain our underweight view on growth fixed income, consistent with our quality bias. In our view, spreads don’t compensate investors for the elevated risk of recession. We remain moderately bullish on commodities but now prefer energy over metals, which could remain weak given China’s ailing property market and a weakening global cycle.

Equities: Global Challenges Weigh Most Heavily on Europe and EM

We continue to prefer US and Japanese equities over Europe and EM. Geopolitical tensions and the energy crisis remain an overhang in Europe, with the almost complete shutdown of Russian gas making a recession a more likely scenario. Valuations, earnings expectations, and positioning reflect a more pessimistic outlook (Europe is cheapest among developed markets) but could have further to fall to reach recessionary levels.

While European Union and UK measures aimed at supporting households, relaxing fiscal rules, and limiting energy prices will help, more policy tightening is needed in Europe. Entrenched inflationary pressures mean that the ECB and the Bank of England will need to continue to hike, even into a recession. In the UK, expansionary fiscal policy has exacerbated the twin-deficit problem and stoked fears of a balance-of-payments crisis.

European energy supply should remain constrained until at least 2025–2026, when meaningful new sources of gas come to market. Over the short-to-medium term, this could leave European energy prices at multiples of US prices (FIGURE 2), leading to the risk of energy rationing and a potential loss of relative production and competitiveness. This is reflected in a weaker euro, which has partially offset tighter financial conditions and supported European-equity outperformance in local-currency terms, but eventually the burden of adjusting to weaker fundamentals may shift from currency to equities.

FIGURE 2

Energy Crisis Is More Acute in Europe (1/2/20-8/30/22)
USD/MMBtu

Lines refer to Dutch TTF Natural Gas front-month futures and Generic 1st Natural Gas futures on the New York Mercantile Exchange. Source: Bloomberg.

While policy in EM (China in particular) is turning incrementally less restrictive, headwinds to profitability and China’s regulatory uncertainty and real-estate crisis still add up to a challenging outlook. Aside from some commodity exporters, EM are hampered by higher prices and constrained food and energy supplies. Geopolitical tensions and the eventual realignment of supply chains are added risks.

The hawkish Fed and strong USD are weighing on risk appetites broadly—especially in EM.

The hawkish Fed and strong USD are weighing on risk appetites broadly—especially in EM. We’ll look for evidence of a reversal in the dollar (e.g., other central banks becoming more hawkish relative to the Fed) and a more forceful policy turn in China before revisiting our moderately underweight view on EM.

Given our concerns about Europe and EM, and about global equities overall, our preference for US equities is a relative one. Higher valuations and earnings expectations in the US reflect more optimism about its outlook vs. the rest of the world, which we think is justified given a strong labor market, resilient corporate fundamentals, and a high degree of energy independence. Inflation expectations are more contained, and there are signs of cooling in goods prices, as well as early signs from a turn in home prices that broader shelter prices could peak in coming months. If we see a global recession, cyclical stocks will underperform—also supporting the US on a relative basis.

Japanese equities could benefit from favorable valuations and a weak currency. Despite acute pressure on the yen and some concerns about upside risks to inflation, the Bank of Japan (BOJ) remains committed to yield-curve³ control, instead leaning into direct-currency intervention to defend the yen. Even if the BOJ were to tweak its yield-curve control approach, the policy mix would still be more supportive than in other regions when combined with likely fiscal expansion. If Japan can create the right kind of demand-driven inflation, especially via wage growth and employment of younger cohorts, it may be able to accelerate nominal economic growth.

Our favored sectors are materials and energy, where supply/demand tailwinds remain strong. Company fundamentals appear attractive in both sectors thanks to capital discipline, reasonable multiples, strong cash flows, and well-behaved credit spreads. Across sectors, we prefer companies with pricing power, long-term margin stability, and healthy balance sheets given their potential to fare relatively well amid cost pressures and volatility.

Commodities: Demand Destruction in a Slowing Global Economy

We maintain our moderately overweight view on commodities. We continue to see opportunity in the energy complex given structural supply challenges that have helped drive roll yields⁴ into positive territory (backwardation).⁵ However, we’ve shifted our view on industrial metals to neutral: We think demand erosion from a slowing global cycle will outweigh the benefits of supply bottlenecks; this means short-term pressure on prices is likely.

We have a moderately underweight view on gold as it faces a mixed picture as the balance of risks shifts from a stagflationary scenario toward a growth slowdown.

Fixed Income: More Positive at Higher Yields

We think the bond markets are ahead of the equity markets in terms of being priced for the Fed’s forecast peak federal-funds rate (as shown in FIGURE 1 above). The Fed’s median forecast of 3% inflation (based on the Personal Consumption Expenditures Price Index)⁶ and a federal-funds rate of 4.6% in 2023 implies a positive real rate of over 1.5%, which we would consider restrictive in real terms (and that, of course, is the Fed’s policy goal). Yields near 4% on US 10-year Treasuries and the Fed’s clear willingness to sacrifice growth make us confident that valuations of US government bonds are attractive. The key question is whether the Fed’s terminal rate needs to go higher to bring down inflation.

In Europe, we’re cautious on the rates market. Our macro team has a higher-than-consensus view on European inflation and ECB hikes and is below consensus on GDP, which suggests a more stagflationary environment than in the US. Fiscal spending is high and rising, which could heat up demand even as the ECB is trying to stanch it.

We lowered our view on investment-grade (IG) corporate bonds from moderately overweight to moderately underweight since spreads aren’t particularly wide given our base case of recessionary conditions. We also think spreads aren’t wide enough in growth fixed income to compensate for higher defaults in a recession. That said, all-in yields of around 5.5% in IG and more than 9% in high yield may be attractive for investors seeking income and as an alternative to equities.

We also see select opportunities in short-end credit, given low dollar prices and attractive carry, and in structured credit, where older vintage non-agency residential-housing assets may be well insulated from losses given the equity built up in these structures.

Downside risks include a severe recession in the US and Europe, extreme currency volatility, and developments in the Ukraine conflict.

Risks

Downside risks to our views include a severe recession in the US that comes about because either the Fed is unsuccessful at re-anchoring inflation or financial conditions tighten excessively. A severe recession is also a downside risk in Europe, where it would mostly likely be precipitated by a prolonged energy crisis and associated cuts in industrial production.

Other downside risks include extreme currency volatility (e.g., markets punishing the currencies of regions with expansive fiscal spending and too-loose monetary policy) and more dramatic developments in the Ukraine conflict, including a higher risk of nuclear deployment by Russia.

Upside risks include a soft-landing scenario, in which the Fed tightens policy just enough, and significant policy intervention in China. On a micro level, corporates may be able to maintain pricing power, thus preserving margins, and sustaining earnings growth over a 12-month period at higher levels than consensus currently expects. Another upside risk to our equity underweights (whether overall or regional) is that valuations, especially in Europe and EM, have adjusted to more than fully reflect earnings and other risks.

Investment Implications

Here are five things investors may want to consider:

Tilt toward quality — Synchronized central-bank tightening is likely to slow the global cycle. We think the focus should be on companies with pricing power, long-term margin stability, and healthy balance sheets given their potential to fare relatively well amid cost pressures and volatility. Company fundamentals in the energy and materials sectors appear attractive thanks to capital discipline, reasonable multiples, strong cash flows, and well-behaved credit spreads.
Prepare for regional divergence — While many central banks are tightening policy at the same time, we expect individual economies and markets to behave differently. For example, European equities and rates appear vulnerable to drawdowns compared to the US. Currency exposure bears watching, as we could see more cases of a country’s fiscal and monetary policies working at cross purposes—such as the one that sent government bond yields soaring in the UK—which could create market dislocations and investment opportunities.
Selectively rebuild defensive fixed-income exposure amid higher volatility — High-quality fixed income looks more competitive vs. equities from a yield perspective and could offer upside and diversification once a slowing cycle gains traction.
Seek inflation protection — While demand destruction is a headwind for commodities, a continued supply/demand imbalance could push oil prices higher, as could output cuts signaled by OPEC. We think Treasury Inflation-Protected Securities⁷ breakevens remain attractive, as do some real assets.
Approach credit cautiously — Spreads aren’t particularly attractive given the higher risk of recession. That said, we see opportunities in structured credit, particularly in older-vintage non-agency residential housing, and in short-duration⁸ credit.

The views expressed here are those of the authors and Wellington Management’s Investment Strategy Team. They should not be construed as investment advice. They are based on available information and are subject to change without notice. Portfolio positioning is at the discretion of the individual portfolio management teams; individual portfolio management teams and different fund sub-advisers may hold different views, and may make different investment decisions for different clients or portfolios. This material and/or its contents are current as of the time of writing and may not be reproduced or distributed in whole or in part, for any purpose, without the express written consent of Wellington Management or Hartford Funds.

Talk to your financial professional about how you can position your portfolio amid market uncertainty.

¹ Spreads are the difference in yields between two fixed-income securities with the same maturity but originating from different investment sectors.

² Risk assets refer to assets that have historically exhibited a significant degree of price volatility, such as global equities, commodities, high-yield bonds, real estate, and currencies.

³ Yield curve is a line that plots interest rates of bonds having equal credit quality but differing maturity dates; its slope is used to forecast the state of the economy and interest-rate changes.

⁴ Roll yield is the amount of return generated in the futures market after an investor rolls a short-term contract into a longer-term contract and profits from the convergence of the futures price toward a higher spot or cash price.

⁵ Backwardation is when the current price of an underlying asset is higher than prices trading in the futures market.

⁶ The Personal Consumption Expenditures (PCE) Price Index is a measure of the prices that people living in the US, or those buying on their behalf, pay for goods and services. The PCE price index is known for capturing inflation (or deflation) across a wide range of consumer expenses and reflecting changes in consumer behavior.

⁷ Treasury inflation-protected securities are Treasury bonds that are adjusted to eliminate the effects of inflation on interest and principal payments, as measured by the Consumer Price Index.

⁸ Duration is a measure of the sensitivity of an investment’s price to nominal interest-rate movement.

Important Risks: Investing involves risk, including the possible loss of principal. • Fixed income security risks include credit, liquidity, call, duration, and interest-rate risk. As interest rates rise, bond prices generally fall. • The value of inflation-protected securities (IPS) generally fluctuates with changes in real interest rates, and the market for IPS may be less developed or liquid, and more volatile, than other securities. markets. • Loans can be difficult to value and less liquid than other types of debt instruments; they are also subject to nonpayment, collateral, bankruptcy, default, extension, prepayment and insolvency risks.
• Investments in high-yield (“junk”) bonds involve greater risk of price volatility, illiquidity, and default than higher-rated debt securities. • Foreign investments may be more volatile and less liquid than US investments and are subject to the risk of currency fluctuations and adverse political, economic and regulatory developments. These risks may be greater, and include additional risks, for investments in emerging markets or in a particular geographic region or country. • Investments in commodities may be more volatile than investments in traditional securities. • Investments focused in specific sectors may be subject to increased volatility and risk of loss if adverse developments occur. • Different investment styles may go in and out of favor, which may cause an investment to underperform the broader stock market. • Diversification does not ensure a profit or protect against a loss in a declining market.

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About The Authors

Nanette Abuhoff Jacobson

Managing Director and Multi-Asset Strategist at Wellington Management Company and Global Investment Strategist for Hartford Funds

Nanette Abuhoff Jacobson consults with clients on strategic asset allocation issues and works with investment teams throughout Wellington to develop relevant investment solutions across asset classes.

Supriya Menon

Multi-Asset Strategist at Wellington Management