CIO Roundtable: Recession Watch
Investors are on recession watch as policymakers aggressively hike interest rates and tighten the money supply to catch up with record-high inflation. While efforts so far appear to be curbing U.S. headline inflation, a look at core services versus core goods shows a distinct divide—the volatile goods inflation may have peaked, but the services component is still on the rise.
And economic growth is decelerating not only in the U.S. but also around the world. Economists have cut GDP forecasts for both this year and next.
How do you manage asset class exposures in this very volatile, very unusual market environment? Hear our chief investment officers’ (CIOs’) thoughts on issues moving markets, asset classes and sectors in the months ahead. Read key takeaways from the replay below.
Shelter Component Major Driver of U.S. Inflation
Although certain consumer prices recently moderated, we still expect inflation to remain volatile and elevated. In particular, the shelter component, representing approximately one-third of CPI, has been rising. However, housing prices are showing signs of abating, and rents should eventually follow—that’s when we could see moderation in the services component of inflation. Nevertheless, we expect inflation to be higher structurally over the longer term.
Labor Market Holds the Key in the U.S.
The labor market is a key driver of U.S. core inflation and a crucial indicator of how much the Federal Reserve (Fed) can tighten. The unemployment rate has remained unusually low despite the economy’s overall weakness, suggesting the Fed may need to remain aggressive to reduce excess demand in the economic system.
Furthermore, reduced labor participation has fueled wage inflation. Wages correlate with tight labor market conditions and CPI. Thus, wage pressure must decline for inflation to meaningfully abate and bring back some stability to financial markets.
When Will the Fed Pivot?
Looking over the past 50 years—nine hiking cycles—the Fed has never stopped raising interest rates until the federal funds rate was greater than CPI. Clearly, there’s still quite a bit of work left, which suggests the Fed will hike a few more times to bring down CPI.
Fixed Income: 3 Distinct Themes
Shift from underweight duration to overweight duration. As the 10-year Treasury approaches 4%, we believe rates can go back to playing their traditional role as a hedge against risk. Therefore, we’ve started building back duration in our portfolios.
Maintain inflation-protection exposure. Even if headline inflation slowly declines, we expect the structural component to keep inflation higher over the longer term. We believe inflation-protection strategies, particularly with short durations, are attractive as rates continue to rise and inflation remains elevated.
Don’t overweight risk. We are defensive on corporate credit—underweight both investment grade and high yield. We also generally favor single A-rated securities over triple B. We continue to underweight agency mortgage-backed securities, and we are very selective on structured credit. We also are very defensive on emerging markets debt but favor low beta countries and those well into their rate-hiking cycles.
Equity: Focus on Value and Quality
From a global perspective, value stocks trading at significantly wide relative valuation discount. Despite the recent outperformance of value, it looks like it still has room to run. The environment today is similar to the recession in 2001 and 2002 when value outperformed coming off the really strong outperformance of growth during the tech bubble. Today, we're coming off a long period of growth outperformance as well, led by the strong performance of technology and risk assets during the pandemic.
Quality stocks enjoying tailwinds. Quality companies are trading at a relative discount to what you typically expect. And higher-quality companies, which typically trade at a premium valuation to average quality and the overall index, are now trading at valuation discounts or at parity. We don't believe the situation is sustainable, and it has, in fact, somewhat corrected itself so far this year.
Outlook for the Dollar
To understand where the dollar goes from here, we really need to understand the two driving forces—inflation and the Fed. We believe U.S. inflation is peaking. When it comes down, the Fed can pivot, which likely will have the biggest impact on the dollar. Having said that, we believe inflation is sticky here, especially the service component. While we don't see the dollar falling anytime soon, we believe we're in the later stages of a strong dollar.
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