Principal Monthly Viewpoints (April 2022)
Q: Principal Asset Management (Asia) Investment Management Team
A: Crystal Chan, Principal Asset Management (Asia) Senior Investment Specialist
Q:Considering all the uncertainties, what is the outlook for the global economy?
A:The conflict between Russia and Ukraine continues to affect the global economy and cause a high degree of uncertainty, as continuation, resolution, or escalation – these three scenarios of the conflict shall trigger very different effects, with the situation cooling down after a while continues to be our base case scenario. Nonetheless, with economies of Russia and Ukraine more likely to undergo recession, coupled with the impacts on oil prices and inflation, global economic growth this year may moderate to 3.5-4%.
The European economy, which is more broadly connected to Russia, will be particularly affected, as weaker output, foreign trade and financial conditions may drag growth down by 1-1.5%, while US and other economies will be less affected overall. However, with the situation in Europe possibly hurting exports, and growth getting impeded by tighter financial conditions, US GDP may also be impacted by approximately 0.5%. If the war continues for an extended period or even worsens, pushing energy prices higher, triggering a further rise in inflation and financial conditions tightening considerably, the impact on investment markets and the economy will be much more pronounced.
Meanwhile, markets are facing the possibility of swifter policy tightening by the Fed. High inflation and relatively tight labor markets in the US imply that the Fed is likely to hike rates at each one of the remaining FOMC meetings this year. However, the path of future rate hikes is highly uncertain, as there could be more than seven hikes this year. At least one 50 bps rate hike may be needed in the second quarter, while the policy rate in the first half of the year may be increased by 1.25%. The only certainty is that the Fed will do whatever it takes to stabilize prices.
Balance sheet reduction by the Fed is another issue which markets are closely watching. According to the minutes of the Fed March meeting, the Fed may announce and begin shirking the balance sheet in the next policy meeting in May. The current consensus is around $95 billion a month, representing a maximum of $60 billion in Treasuries and $35 billion in mortgage-backed securities would be allowed to roll off. Depending on how the economy evolves, if the U.S. economy does not sink into a recession, the entire reduction program may last for two to three years. The scale of the balance sheet may subside to below $6 trillion by 2024 eventually. That total would be about double the rate of the last effort, from 2017-19.
Q:Does inversion of the US yield curve hint at economic recession?
A: After results of the FOMC meeting in March were announced, expectations of rate hikes by the Fed caused the yield of short-term US Treasuries to surge relative to longer-term Treasuries. This resulted in the yield of 2-year Treasuries surpassing 2.4%, which had created an inversion of the 2-10 year Treasury yield curve at the end of March, the first time in two and a half years.
This triggered market concern as yield curve inversion is usually viewed as a signal of a looming economic recession. Since the 1950s, the US Treasury yield curve has become inverted every time before the economy went into recession. The current yield of 10-year US Treasuries is slightly higher than our predictions for the end of the year, but is still expected to rise further in the short-term along with inflation expectations. At the same time, markets are factoring in the possibility of the Fed hiking rates by 50 bps at each of its meetings in May and June. Two-year Treasury yields, which are more sensitive to rate hikes, may rise at a quicker clip, which means that inversion can happen again within the quarter.
The elapsed time between the first yield curve inversion and actual economic recession has varied, but typically it takes 12 to 18 months on average, sometimes even as long as four years. Looking at past rate hike cycles, the economy is more likely to continue growing in the first year of tightening until the rate hike cycle is nearly over. In the short run, the US economy is unlikely to enter recession, as at least no risk signals are being seen from corporate activities. Despite the recent setback in stock markets and widening of spreads in corporate bonds, there is still insufficient indication of an economic recession.
Assuming geopolitical tensions shall be resolved after a while, oil prices revert from its high to around USD 80-90 by year end, supply chain issues are gradually smoothened in the second half of the year, and inflation starts to decline, the Fed may hike rates more slowly next year after substantial rate hikes this year, allowing the US economy to maintain an expansionary pace in 2022 and 2023. However, with economic growth currently facing greater downward pressure, in our downside growth scenario, the US economy may enter recession at the soonest in the second half of next year, forcing the Fed to cut rates again.
Q: How should investments be allocated in the second quarter?
A: With global economic growth facing greater downward pressure, inflation remaining high, monetary policy tightening and higher investment volatility, financial conditions may enter the neutral territory. Coupled with a series of uncertainties, we have downgraded our equity outlook to neutral in the short-term. Among them, we are slightly optimistic about Japan, neutral in the US., Asia, China and Hong Kong, while slightly bearish in Europe.
However, despite a deteriorating global growth outlook, equities fundamentals have improved in the past quarter. Except for the US, the valuation of global equity has receded to a level closer to 10-year average. Capital may extend a 19-month trend and continue to flow towards equities. Sentiment may turn more positive on eventual easing geopolitical tensions and oil prices. Negative real rates are likely to support equity performance as well. Therefore, stocks are still likely to generate greater returns than bonds by the end of the year. From a longer-term investment perspective, investors may consider maintaining a higher proportion of stocks than bonds.
For the second quarter, we remain neutral on fixed income overall. Although geo-political risks and other uncertainties may cause a flight towards safety, treasury yields are expected to go higher with higher inflation expectations. We remain slightly bearish on sovereigns. Given the relatively strong health of the corporate sector, further spread widening may be limited going forward. At the same time, the hunt for yield from investors remains strong. Investment-grade is neutral. As for high-yield bonds, given healthy corporate fundamentals, defaults should stay limited. However, increased downside risks in the global economy may affect investors' risk appetite, we have downgraded our overall view to neutral.
(Written on 11th April 2022)
Crystal Chan
Senior Investment Specialist
Principal Asset Management (Asia)