Alea Iacta Est
Investors entered this year worrying about imminent recession risk and hoping for declining inflation and a pivot from central bankers. The consensus called for a reversion to the mean, back to a world of stable inflation, stable interest rates and stable profits.
We are no longer in that world.
The Rubicon has been crossed.
The goldilocks equilibrium of low interest rates, rising asset prices and global trade is breaking before our eyes.
The increase in oil prices, in geopolitical tensions and in interest rates over the past few weeks confirm we are reaching a point of no-return across politics, geopolitics and markets.
What does this mean for investors?
Central banks have navigated the path between a too hot and a too cold economy relatively gracefully, so far. But the first half of the inflation normalisation journey was the easy part. What lies ahead is a tougher choice between price stability and macro/financial stability.
How far will central banks go in their fight against inflation, and which parts of the financial system are likely to break?
Some central banks will choose to prioritise growth and let inflation run hot, at the cost of losing credibility and/or making inflation more entrenched. Others will stay hawkish for longer, at the cost of hurting the economy.
Today, the Fed continues to portray a soft landing as a possible scenario, but this is gradually fading from its base case. Following the September Fed press conference, risk assets have been waking up to the reality that higher-for-longer rates are here to stay. Short and long-end yields have broken new highs. The multi-decade bull run in bonds is over, and “the year of the bond” consensus proved wrong. But the ripple effects go well beyond bond markets.
What does the new world look like, and which assets are attractive in this new environment?
There are plenty of risks out there. Many assets and capital structures which have survived a long era of low yields, are still not priced for persistent interest rates.
There are also more opportunities. In the first half of the year, investors flocked to investment grade bonds on the idea that all-in-yields would compensate for most risks – despite low spread levels – and that once inflation would stabilise, a rate cut cycle would come. Our stance on duration, as discussed also in our latest investor webcast, remains more cautious. It is still too early to buy government debt.
Credit, instead, is becoming attractive. Volatility will persist and default rates will rise. Unlike during the buy-the-dip decade, firms without pricing power or with too much leverage will no longer be able to kick the can. But investors will get paid handsomely to pick the right credits.