That risk is very real. As seen by financial conditions loosening in the aftermath of the Fed’s comments at the recent federal open market committee meeting, inflation could easily surprise to the upside once again, with the uncertain geopolitical backdrop offering few guarantees that oil prices will remain subdued or that gas prices in Europe will not drift higher as we head into winter.
If headline inflation rises again, the fear is that core inflation will follow due to second-round effects, dragging us back into a wage-price spiral. The more duration investors run in this scenario, the worse their returns may be.
In the UK and Eurozone, where growth is sluggish, the picture is slightly different.
Both regions seem more likely to slide into recession this year, and, as a result, the BoE and ECB will be less hawkish, fearful of hiking into weakness.
While we expect credit spreads to widen in 2024, these two central banks will have more room to cut rates in order to support growth, which will be a good environment for short-dated bonds.
Why not just move into cash?
Money market funds have seen significant inflows in recent months as rate rises have meant that, for the first time in a long time, they can compete for capital with other asset classes.
Their appeal is, of course, clear: we are in a high-risk environment and cash offers near riskless return.
Certainly, investors are right to want to weather-proof their portfolios, but we still believe they can achieve that aim without resorting to an asset class that has obvious limitations and a poor long-term track record relative to most risk assets.
That said, we do not believe that equity markets right now are priced for a recessionary environment, with the equity risk premium lower than one might assume.
In a higher-for-longer rate environment, investors should expect valuations to better reflect the massive pressure under which the real economy is starting to come, with leading indicators demonstrating worrying evidence of deterioration.
But short-duration fixed income, after all these rate rises, has become something of a no-brainer.
Today, you can construct a relatively low-risk portfolio of credits and sovereign bonds yielding 6 per cent to 6.5 per cent, offering an attractive return even if the market goes nowhere.
At the short end, there is protection if rates rise and the potential for significant outperformance when rates start to fall.
And when that does happen, the return from money market funds will not be as attractive.
