We think the Federal Reserve’s (Fed’s) efforts to tame record inflation will prove to be too little too late.
Investors are facing a historic combination of domestic and global challenges, which ultimately may trigger a divided world order.
We are taking a more defensive approach in this environment.
Top of Mind
Investors had hoped 2022 would be the year the market finally recovered from the pandemic and life started to feel a little more normal. So far, though, even as the pandemic’s effects have faded, the return to normal remains on hold.
Russia’s invasion of Ukraine delivered an unexpected, rude awakening. Whether this conflict turns into a new Cold War or even World War III remains to be seen. But sanctions and the war’s impact on the global economy and financial markets are already profound.
Geopolitics isn’t the only shock facing investors. Soaring inflation, record gas and commodities prices and continued supply chain disruptions are weighing on sentiment. Additionally, recession concerns and the Fed’s policy responses further complicate investors’ decisions.
The Fed’s Difficult Mission
With the Fed finally launching a rate-hike campaign to fight 40-year-high inflation, the ultimate question facing investors is this: Can the Fed engineer a soft landing to tame inflation and avoid a recession?
Fed Chair Jerome Powell thinks it can. We have our doubts.
As Figure 1 illustrates, the historical interaction between inflation and the Fed Funds Rate shows a clear, consistent pattern. Fed tightening cycles have typically resulted in recessions, particularly when inflation was high and ascending.
Figure 1 | When the Fed Has Tightened, Recessions Have Followed
Data from 1/31/1965 – 6/30/2022. Source: Bloomberg.
Today’s extraordinary domestic and global circumstances are of even greater proportions, making a soft landing even more challenging.
Consider this daunting data:
Year-over-year inflation is 8.3%, a 40-year high.1
The U.S. money supply2 is up 42% over the past two years, an 80-year high.3
Short-term interest rates are at or close to record lows in the U.S., Europe and most developed markets countries.
The U.S. fiscal deficit ($678 billion total for the first half of fiscal 2022) is the largest since World War II.4
The U.S. federal debt to GDP (gross domestic product) ratio (123% as of the fourth quarter of 2021) is near an all-time high.5
Many raw materials and agricultural commodities are at record-high prices.
Russia’s invasion of Ukraine marks the first major war in Europe in nearly 80 years.
Economies haven’t fully recovered from COVID-19, the first pandemic in 100 years.
Diminishing Deflationary Trends
We believe the confluence of these events suggests seismic shifts in the global geopolitical and economic order are likely afoot. Powerful deflationary forces, such as globalization, technology innovation and aging demographics, have dominated the global socioeconomic landscape for the past 40 years. But new secular trends are emerging, threatening the impact of the deflationary influences.
Perhaps the most profound is a potential shift from globalization to a new world order.
As the renowned China scholar Michael Schuman at the Atlantic Council aptly put it, “The Russian invasion of Ukraine and a series of COVID-related shutdowns in China do not, on the surface, appear to have much in common. Yet both are accelerating a shift that is taking the world in a dangerous direction … What could emerge are two semi-distinct spheres, with tighter economic ties within than between them. Each will use different technology and operate on different political, social and economic norms.”
Heading Toward a Divided World?
This secular shift, if it persists, threatens the economic interdependence and global supply chains meticulously built over past decades. An increasingly divided world would reduce the global flows of trade, capital, labor, commodities, technology and manufactured goods, triggering shortages and higher costs.
This new world order would force adjustments to the way we produce, consume, trade and price. Nations would embark on a painful and protracted multiyear to multidecade process that would affect financial markets and investment decisions.
In this context, inflation and yields probably hit their generational lows in 2020 and may settle notably higher.
Brace yourself for a new world.
Looking Forward in the Bond Market
We expect the trends witnessed at the start of the year to continue through the second quarter. Persistently high inflation will continue to force the Fed and other major central banks to raise rates and shrink their balance sheets through asset redemptions and sales. Interest rates should continue their march higher.
Bond valuations likely will remain volatile, as higher yields reinforce concerns the Fed will not be able to orchestrate a soft landing in coming quarters. While currently not our base case, the prospect for stagflation will linger on investors’ minds, increasing the prospects for higher volatility.
Given the likelihood of a prolonged period of high inflation, increased volatility and an uncertain global growth trajectory, we believe maintaining a defensive approach is prudent. Accordingly, our portfolios are positioned with less interest rate sensitivity relative to benchmarks. We also favor inflation protection through exposure to inflation-linked bonds.
We believe the creditworthiness of bond issuers generally remains steady. However, we think increased geopolitical risk and slowing growth call for underweight exposure to corporate credit and market weight in structured credit. We are underweight agency mortgage-backed securities (MBS) as the sector is particularly exposed to the Fed’s balance sheet reduction.
March 2022, U.S. Consumer Price Index.
Measured by M2, which includes cash, checking and savings deposits, money market securities and highly liquid time deposits.
Source: U.S. Federal Reserve.
Source: U.S. Treasury.
Source: Federal Reserve Bank of St. Louis.
The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.