Fed Policy’s Long and Variable Lag Reinforces Recession Risk

As economist Milton Friedman once indicated, monetary policy typically comes with long and variable lags in terms of its impact on the economy. The Federal Reserve (Fed) remains resolute in its battle against inflation, with great uncertainty surrounding the eventual economic cost. Our outlook calls for continuing volatility, meriting a more cautious and high-quality posture in our bond portfolios.

Recession Risk Is Rising

The Fed and other central banks continue to battle a persistent menace — raging inflation. So far, the series of aggressive interest rate hikes have been no match for U.S. inflation, which remains at early-1980s levels. The only cure may be a recession, and it appears that monetary policy will likely trigger an economic downturn and continued elevated financial market volatility.

In Europe, where inflation stands at a record high, the European Central Bank (ECB) is increasing rates for the first time since 2011. U.K. inflation is also at 40-year highs, despite the nation’s central bank lifting borrowing costs to their highest level since 2008.

The combination of elevated inflation and restrictive monetary policy is driving a dramatic slowdown in U.S. economic growth. In the eurozone and the U.K., growth outlooks are plummeting as the regions contend with an escalating energy crisis as winter approaches.

The depth of a recession remains highly uncertain, largely due to the long and variable lag associated with monetary policy setting. Persistently high inflation is not affording central banks the time to gauge the actual economic impact of the rate hikes already enacted.

Prior rate hikes may ultimately cool the economy sufficiently to relieve much of the inflationary pressure. But month-to-month inflation data is pressuring central banks and fueling policymakers’ consistent tightening bias. Overtightening is now a critical risk to the global economy.

Overtightening May Be a Necessary Price to Pay

Several longer-term structural factors are supporting inflation. Additionally, forces specific to today’s post-pandemic cycle are exacerbating the inflation challenge.

For example, labor participation remains below the pre-pandemic rate. The exodus of workers has coincided with a surge in demand for employees as the economy seeks to rebound from the pandemic’s effects. This supply-demand imbalance has increased the cost of labor for businesses while boosting consumers’ willingness to spend amid rising wages.

Furthermore, deglobalization trends and still-clogged supply chains have also contributed to inflation.

Therefore, the Fed is motivated to act aggressively against relentless inflation. In our view, such action is necessary to avoid the mistakes of 1970s monetary policy, which extended the pain of inflation. A 1970s repeat would potentially be a bigger problem than the current growth slowdown.

The Fed appears to share this view. We believe policymakers are more comfortable with the risks of overtightening than the risks of undertightening.

Volatility Is Here to Stay

Amid continuing macro uncertainty, we believe market volatility will remain heightened in the months ahead. Lingering geopolitical tensions will also further aggravate the investment backdrop.

Accordingly, we remain cautious in our fixed-income portfolio positioning and sector strategies, with a preference for higher-quality fixed income. We have also increased duration because we believe there will be more demand for high-quality securities heading into a recession.

Sector Views: A Time to Be Cautious With Credit Risk

As market participants increasingly focus on recession risk, we believe the dominant risk in fixed-income markets will shift. We expect investors’ primary concern to move from interest rate risk to credit risk. Here’s how our sector teams are responding:

U.S. Government

We see value in the intermediate portion of the Treasury yield curve, where yields may be peaking and likely will decline as the economy slows. Despite recent easing in inflation, we still believe U.S. Treasury inflation-protected securities (TIPS) serve an important role. We expect inflation to stay elevated and well above the Fed’s target, largely due to the services component of the Consumer Price Index.

U.S. Securitized

Amid heightened recessionary concerns, we favor strong secular growth stories, including data infrastructure and federally guaranteed student and housing debt securities. Ongoing COVID-19-related recovery stories, particularly in narrow-body commercial aircraft, also are appealing. Additionally, we see value in senior collateralized loan obligations (CLOs), which historically have withstood economic cycles and benefited from high floating-rate coupons.

U.S. Corporate

Our outlook for continuing market volatility and economic uncertainty merits maintaining more defensive positioning among U.S. corporates. We expect inflationary pressures and slower economic growth will continue to affect corporate profits and weigh on credit fundamentals. As spreads widened in the third quarter, we found opportunities to add to higher credit-quality issuers trading wide relative to our targets. We also believe U.S. banks appear relatively attractive versus industrials due to stable fundamentals with wider relative spreads.

Municipal

We currently favor a neutral duration stance, but as the economy heads into recession, we expect to extend interest rate risk. We are finding value in intermediate- and longer-maturity securities, as relative value has diminished at the front end of the yield curve. With slowing growth modestly pressuring credit spreads, we continue to focus on higher quality securities and sectors. If spreads widen further, we expect to add credit exposure.

Non-U.S. Developed Markets

In Europe, we are maintaining neutral duration, with an overweight in semi-core countries, including France, Finland and Ireland, offset by an underweight in Germany. We expect the ECB to continue increasing its policy rate amid extremely high inflation expectations. Meanwhile, the region’s growth outlook remains relatively weak, and we believe recession probability is high. The Russia/Ukraine conflict continues to rattle energy markets, and energy prices account for a large portion of Europe’s high inflation rates.

Our portfolios have moved to a slight U.S. dollar short in response to Fed policy. The Fed has surpassed other global central banks in the rate hike cycle and may be closer to ending its campaign.

Emerging Markets

Amid tighter global financial conditions, geopolitical conflicts and a likely global recession in 2023, recent investor outlooks toward emerging markets were dire. The slowdown in China and in international trade helped fuel this view. But the recent easing of inflation data and a soft pivot on zero-COVID policies in China have opened some breathing room for emerging markets.

In our view, Latin American countries are still better positioned to withstand further shocks. The region has already faced tighter monetary and fiscal policies, and inflation has generally peaked. Valuations appear attractive for select sovereigns with strong fundamentals. However, we are waiting for a weaker U.S. dollar and lower volatility in U.S. rates before boosting exposure.

Money Markets

Given expectations for elevated inflation, a still-hawkish Fed and a higher-for-longer terminal rate, we favor floating-rate commercial paper and CDs over fixed-rate instruments. Market participants expect $1 trillion in Treasury bill issuance from late 2022 through 2023. Accordingly, on a strategic basis, we plan to purchase fixed-rate Treasury bills with maximum tenors of February 2023. Tactically, we plan to purchase newly issued Treasury bills longer than February 2023, expecting to exit these positions for capital gains and net asset value (NAV) stability. We are also focused on maintaining excess liquidity and NAV stability amid continued volatility and the highly anticipated Securities and Exchange Commission decision on money market funds reform.