In this Q&A with Sarah Riopelle, she looks back at an eventful first half and provides her perspective on what to expect in the markets for the balance of the year.
We've seen a meaningful increase in volatility recently as markets adjust to changes in the economy. What are your expectations for the economy going forward?
Consumers and investors are feeling on edge as extremely high inflation has led to a rapid rise in the cost of living and pushed central banks into an aggressive round of tightening. Price increases have been larger and lasted longer than most experts had predicted due to a variety of headwinds including supply-chain challenges, rapidly changing consumer demands, the war in Ukraine and the lingering impact of the massive monetary and fiscal-stimulus packages deployed during the pandemic.
Central banks are now in a tough position where they need to rein in problematically high inflation at a time when the economy has already begun to slow. The combination of aggressive rate hikes, a commodity-price shock and elevated inflation suggests that the risk of recession is higher than usual.
Moving forward, consensus estimates for growth continue to be ratcheted lower and those for inflation revised higher. Our own forecasts are below consensus for growth and above consensus for inflation. We do think, however, that any recession that comes to pass would not be as severe or damaging as the ones following the global financial crisis and the COVID-19 pandemic.
Weighted average consensus CPI
Note: as of June 2022. Source: Consensus Economics
Now that the U.S. Federal Reserve (Fed) is focused on tackling high inflation, are we seeing signs that their efforts are working? Where do we go from here?
Although there are signs that inflation pressures could be peaking in the near term, the gap between where inflation is and where central banks want it to be is still unacceptably large.
This gap has led to an acceleration in monetary tightening by central banks with the Fed hiking short-term interest rates by an unprecedented 75 basis points in mid-June. Fed Chair Jerome Powell reiterated his commitment to getting inflation back to the 2% level, but the question for investors is how much does the Fed need to raise rates to get inflation under control?
The market is pricing in a fed funds rate of around 3.25% by mid-2023 (we are currently at 1.75%). There is a fair chance that tightening ultimately undershoots current lofty expectations, but it is dependent on when we start to see inflation coming down. At this point, though, the Fed still has a lot of work to do and will likely remain firm on rate hikes until we see the actual inflation readings start to fall.
Implied fed funds rate
Note: as of June 23, 2022. Source: Bloomberg, U.S. Federal Reserve, RBC GAM
How are you positioning your portfolios given the current environment?
The macroeconomic backdrop is highly uncertain, which has led to a larger than usual range of potential outcomes. With the risk of recession rising, we felt that it was prudent to reduce our equity weight in the portfolios. In addition, with much of the valuation risk in bonds alleviated, we believe that bond yields are at levels that should offer some protection against a downturn in equities in a balanced portfolio. With this in mind, we have made two asset-mix changes in June. The first was to move 50 basis points out of cash and into bonds as the U.S. 10-year Treasury yield climbed above 3.0%. Later, as yields rose even further, we moved 100 basis points out of stocks and into bonds.
We are still maintaining a slight overweight in stocks recognizing that the risk premium between stocks and bonds still favours stocks, although the premium has narrowed as bond yields have risen. Our asset mix is now much closer to neutral than it has been at prior points in the cycle.
Global stock market composite
Note: as of June 17, 2022. GDP-weighted average of RBC GAM fair value models for a variety of countries. Fair value estimates are for illustrative purposes only. Corrections are always a possibility and valuations will not limit the risk of damage from systemic shocks. It is not possible to invest directly in an unmanaged index. Source: RBC GAM
Market downturns are painful for everyone. Being aware of how your emotions can impact your investment decisions during volatile periods can help you to avoid making poorly timed changes to your portfolio. It's what you do – or rather what you don't do - during these volatile times that can make all the difference.