Originally published on Invesco.com by Tiffany Wilding and Andrew Balls.
In today’s uncertain economic environment, it’s especially important for investors to remain mindful of potential risks.
In our latest Cyclical Outlook, “Fractured Markets, Strong Bonds,” we discuss how restrictive monetary policy appears to be taking effect in the real economy, and what this means for investments. This blog post summarizes our views over the next six to 12 months. The economic backdrop
The recent shocks to the banking sector show that central banks’ efforts to tame inflation are having an intensifying effect, with broader economic consequences likely to follow.
We see three key economic themes over our cyclical horizon:
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Bank failures and rising cost of capital raise the prospect of a significant tightening of credit conditions, particularly in the U.S. – and therefore the risk of a sooner and deeper recession.
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Central banks are likely near the end of their hiking paths, but not tightening further is different than normalizing or even easing policy, which will likely require inflation falling toward target levels.
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Recessionary risks and any further bank stress are unlikely to be met with another large fiscal response unless the economic implications are clear and severe.
Historically, recession and unemployment increases have tended to begin around 2 to 2.5 years after the start of a hiking cycle. The current cycle appears to be evolving broadly in line with this historical timeline.
In past cycles, wage inflation only began to materially decelerate one year after the start of a recession. Since inflation is still likely to moderate only slowly, any actions to normalize or even ease policy are also likely to come with a lag and will depend on how the trade-off between financial stability and inflation risks evolves.
Inflationary lags are likely longer in the euro area, likely keeping the European Central Bank (ECB) hiking beyond the U.S. Federal Reserve. Higher gas prices, a weaker currency, and a less flexible labor market are likely to support a lengthier period of elevated European inflation.
Investment implications
Uncertain environments tend to be good for bonds, particularly after last year’s repricing pushed current yield levels – historically a strong indicator of returns – much higher. Bonds appear poised to exhibit more of their traditional qualities of diversification and capital preservation, with the potential for upside price performance in the event of further economic deterioration.
We continue to expect a yield range of about 3.25% to 4.25% for the 10-year U.S. Treasury note in our baseline view, and broader ranges across other scenarios, with a potential bias to shift the range lower given increased risks.
There are attractive opportunities in short-term, cash-equivalent investments today, given relatively elevated yields near the front end of the curve and potentially less volatility than many other investments. But unlike longer-term bonds, cash won’t provide the same diversification properties and ability to generate total return through price appreciation if yields fall further, as has occurred in prior recessions.
The banking sector stress reinforces our cautious approach toward corporate credit, particularly lower-rated areas such as senior secured bank loans. Recent bank volatility could be a preview of what’s ahead for more economically sensitive parts of credit markets. We retain a preference for structured, securitized products backed by collateral assets.
We believe U.S. agency mortgage-backed securities remain attractive, particularly after spreads have widened lately. These securities are typically very liquid and backed by a U.S. government or U.S. agency guarantee, providing resilience and downside risk mitigation.
Within the financial sector, broad-based weakening has made some senior issues from stronger banks look more attractive. Valuation and greater positional certainty within the capital structure reinforce our bias for senior debt over subordinated issues.
Within private markets, we are starting to see more attractive opportunities in newer deals, but prices of existing assets have been slower to adjust compared with public markets. We’ve been prioritizing liquidity more than usual across our strategies and are prepared to take advantage of market opportunities and dislocations that arise.
Commercial real estate (CRE) may face further challenges, but not all CRE is the same. We aim to stay in senior parts of the capital structure in diversified deals, and to avoid lower-quality, single-asset or mezzanine-level risk.