How to deal with a scenario of rate hikes?

As we approach the second anniversary of the Covid-19 pandemic outbreak, the disease remains a top concern for investors. The coronavirus continues to have the ability to alter demand and supply and this is reflected in episodes of risk in financial markets. Typically, unexpected shocks tend to raise questions about the ability of the world economy to maintain its pace of recovery.

This, in turn, triggers the purchase of supposedly safe assets, generating counterintuitive movements in bond yields when the macroeconomic narrative is one of inflationary growth and higher interest rates.

And it is likely that 2022 will maintain this pattern of market behavior. However, although Covid will continue to be a problem, it is foreseeable that rising inflation around the world will be the main concern. Policy makers dealt with the potential impact of the pandemic on the global economy by aggressively cutting interest rates and loosening fiscal ropes. This first supported and then fueled economic growth and was reflected in higher valuations for corporate assets.

The remedy for inflation is not so benign. Central banks have tried to increase inflation in recent years and are now faced with the possibility of having to reduce it. To do this, interest rates will have to rise in various economies, and that will have very different implications for returns on the bond and equity markets, as well as for economic growth.

Several of the major central banks could start raising official interest rates from crisis pandemic levels over the next year. These movements would start from very low levels and, if the market assumptions are correct, they would be limited in nature. However, it is clear that the era of pandemic crisis monetary policy is coming to an end.

As we approach the global monetary policy shift, it is important to consider different scenarios and how they will impact different profitability expectations for different asset classes. A negative shock to bonds and then equities would only occur if policymakers appear to change their views on long-term equilibrium rates.

If the data that comes in pushes the Federal Reserve to admit that its final interest rate is not 2.5%, but somewhat higher, long-term bond yields and, more importantly, real yields, could move significantly above levels observed in the market during the last two years. This would undermine growth and earnings momentum. Negative bond yields would be quickly followed by large corrections in equity markets.

Portfolios should adapt

However, for now this remains a risk and not the central expectation. Inflation is likely to be transitory, even if high rates persist well into 2022. The idea of ​​returning to wage price spirals in the US and other major economies seems somewhat fanciful. If we are correct, bond markets can withstand a modest tightening of monetary policy. A rate hike of 100 basis points or so would not be a cataclysm for equity investors, who have been rewarded for being in an asset class driven by very high earnings. A slight rise in rates and a slight decline in earnings growth in equities are not reason for bear markets. The ongoing recovery, innovation around climate change and rethinking supply chains should be strong tailwinds for equity investors for some time to come.

However, a little wallet security is not a bad thing. Portfolios should be adapted to protect against a worse than anticipated outcome. That worst result would consist of even higher inflation, a more aggressive tightening of monetary policies and a subsequent reduction in growth prospects. In this regard, inflation-linked bonds have outperformed real inflation in this cycle and should continue to do so in 2022. Other fixed income assets will struggle, but even then, actively managed duration and credit exposures may offer a positive return to investors. It is worth noting that it is very rare to get two consecutive years of negative returns in developed government debt markets. Forecasts of a significant increase in bond yields have been wrong in the past, and could be wrong again. When it comes to equities, companies with less leverage, strong pricing power, and innovative product lines will thrive.

As a conclusion, rising prices will be a necessary part of the energy transition, but it doesn’t have to be something that brings with it significantly higher interest rates and more macroeconomic volatility. In 2022, investors will be very attentive to the peak of inflation and its impact on the behavior of prices and wages. The bullish scenario is that inflation will peak, and the flexibility of the modern world economy, still highly interconnected, will allow expectations to be firmly anchored again.