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The possibility of outcomes in 2023 seems to be a little bit wider than usual. If inflation continues to shock to the downside, capital market returns should be very solid for the rest of the year. Now, that’s a very big “if.”
The Federal Reserve wants inflation to be higher than its long-term goal of 2%. And the longer it takes for inflation to drop to that target, the more likely it is that there will be a recession in 2023 or later.
The US housing market, which is the most affected by interest rates, is slowing down the most. Housing has started to slow for the last six to eight months here and will likely continue to slow.
Certainly not the end of the world, but until the Fed begins to ease or feels more confident that core inflation is approaching 2%, the chances of a US recession are increasing.
In this kind of situation, we tell our clients to improve their liquidity and put more money into US Treasury bonds. High-quality, high-yielding securities still have a good upside or carry in the short term, but you might want to be a little more cautious with assets that have a higher chance of defaulting or going down in value.
Most of the time, a long time and a high yield are opposites. 2022 is the outlier. But the negative relationship between time and credit works very well in most situations. It gives you the option to rebalance when high-yield spreads get wider and interest rates go down. This is because investors think that the Fed will make up for bad economic performance by lowering interest rates. We are able to raise our output in a manner that is not only highly frugal but also very successful in its execution.
We don’t only buy high-yield investments, though. We also try to spread out or reduce the amount of “triple-C” risk, which is related to credit volatility or the risk of default. We will put money into emerging markets, usually hard-currency EM sovereigns or corporates, and sometimes into securitized bonds, which usually focus on US housing and commercial real estate.
The fact that securitized bonds are backed by a separate security is appealing to us. We think that the past increase in house prices limits the potential drawdown. This is especially true now, when investors are worried about a possible slowdown in the US and global economies.
Leave some cash on hand and be ready to rebalance if our view of modest growth is wrong. And in the end, everything is going to come down to the inflation rate.
Be prepared to take some precautions in this area in the event that inflation exceeds expectations to the upside.
