A game of musical chairs: Investor concerns rotate from inflation to growth

25 April 2023

Four key takeaways for what the next few months could hold 

Over the past year, investors have watched closely as the US Federal Reserve aggressively hiked interest rates to curb the highest inflation since the 1980s. Now, as that monetary tightening has been working its way through the economy, we’re seeing investor worries start to rotate away from inflation and toward growth. 

We said at the start of the year that this game of musical chairs would be a key driver for markets in 2023 – and, as we discussed in our March CIO insights, we’re now seeing that start to play out. 

As we move deeper into the second quarter (Q2) of the year, here are our four key takeaways for what the next few months could hold. 

Takeaway #1: Growth is set to weaken further in the US and other developed markets (DMs)

Back in January, we highlighted that a slowdown in growth was starting to take hold in the world’s largest economy. Fast forward to today and a number of data points are adding to the evidence. 

As of March, the US ISM manufacturing purchasing managers index (PMI) has slumped even further to a three-year low of 46.3 amid weaker demand. Consumer spending is declining in categories sensitive to the impact of higher interest rates, like autos and home furnishings. And while the labour market is still tight, a gradual rise in jobless claims and falling job openings add to  signs of softening. (Remember that, historically, employment has been the last shoe to drop during downturns, as businesses are generally reluctant to let go of workers until they really need to.)

Strict lending standards to take a toll on growth 

Tighter credit conditions also point to weaker growth ahead, especially in the wake of the collapse of Silicon Valley Bank (SVB). But even before SVB, banks were increasingly hesitant to lend. 

In our view, the impact of the turmoil in the banking sector is set to filter through to the broader economy in the months ahead. That’s because the smaller banks most impacted by that turmoil account for a big share of lending to small businesses, about 70%, according to Goldman Sachs’ estimates. This is important because these businesses have accounted for almost half of US private-sector jobs and about two-thirds of the new jobs created over the past 25 years or so, according to the US Small Business Association (SBA). 

As you can see in the chart below, when lending standards tighten, a recession is usually not far behind. That’s because when companies have less access to capital, they tend to pull back on investments, cut staff, or (in the worst case scenario) close shop completely.

This isn’t just happening in the US – similar dynamics are at play in Europe. According to the European Central Bank’s (ECB) eurozone bank lending survey, not only are credit standards tightening substantially, loan demand is also in decline.  

Ultimately, while this slowdown in the economy is unnerving to watch, it’s exactly what central banks like the Fed have in mind as they look to rein in inflation. 

Takeaway #2: As growth weakens, the end of central bank tightening is on the horizon

As the US economy weakens – and assuming inflation comes down with it – we see the Fed turning its focus to supporting growth. But as core inflation is still elevated, we see a pause in rate hikes as more likely than the imminent cuts that markets have been pricing in.

And the Fed isn’t alone in this. Other global central banks have started to tap the brakes on their tightening cycles as well. The ECB, for example, is expected to dial back to a 25 basis point (bp) rate increase in May after a succession of 50 and 75 bp hikes. Closer to home, the Monetary Authority of Singapore hit pause on its monetary tightening on policy in April as it assesses risks to growth.

Together, these shifts suggest that central banks are now rebalancing their priorities as the threat of recession looms. 

Growth concerns loom large for investors 

It’s not just central banks who are getting worried about growth – markets are also starting to sweat. 

As we highlighted last month, market pricing on the Fed’s rate path has shifted dramatically, with rate cuts expected in the second half of the year. In addition, the yield curve – while still inverted – has also started to steepen on the back of those expectations, as you can see in the chart below. This could be a worrying sign for growth if this continues, as this behaviour has tended to presage recessions. (See our Jargon Buster if you need a refresher on the yield curve). 

Takeaway #3: China’s growth is bouncing back – but not enough to offset the global slowdown

As these dynamics play out in advanced economies, we see a different set of factors shaping the macroeconomic picture in emerging markets (EMs), particularly in China. 

Indeed, a pickup in China’s Q1 GDP growth to 4.5% year-on-year highlights that the world’s second-largest economy is on a different trajectory compared with the US and other developed markets. In addition, as inflationary pressures have proved more manageable in China, that has given its policy makers more room to stimulate growth – whether through rate cuts or more government spending. 

China’s recovery may offer fewer benefits for the rest of the world

That said, China is not out of the woods yet – its post-Covid recovery is only just starting to take hold, and it’s unclear how long its growth momentum can continue. Consumer spending appears to be powering the economy’s rebound following the scrapping of the country’s zero-Covid policies. 

However, the rebound in consumption is taking place in more domestically-focused, service-oriented industries like tourism, transportation and F&B. That means any positive spillovers to growth to the rest of the world may be limited compared to past economic cycles.

Global demand for China’s exports is also fragile. The Caixin manufacturing PMI – which tends to survey smaller, export-oriented firms – fell back to 50.0 in March (the line that separates contraction and expansion) after jumping to 51.6 in February.

Takeaway #4: USD performance likely to be less volatile as Fed hiking cycle ends 

Starting from about mid-2021, a strengthening US dollar had been the main factor driving global currency markets. That trend accelerated in 2022 as the Fed embarked on its rapid rate hike cycle, with its outsized moves contributing to inflows into dollar assets. Adding fuel to the fire, recession fears in Europe and the global economic slowdown contributed to a risk-off environment that had investors flocking to the greenback as a safe-haven. 

Fast forward to today, we can see the US currency’s strength has already started to recede, with the dollar index down more than 10% from its peak in September 2022. Going forward, we expect USD volatility to come down and its performance to become more range-bound (that is, trade within a more narrow range) as the Fed’s rate hike cycle comes to a close.

As a result, the picture going forward for other currencies may be more nuanced and driven by country-specific factors – for example, interest-rate differentials, growth and inflation dynamics, or even geopolitical risk. But ultimately a more stable USD should remove one layer of complexity when investing in global assets. 

How could these shifts play out for asset classes?

Given the immense uncertainty in the macroeconomic environment, we continue to favour a defensive positioning for our portfolios. Our investment framework, ERAA®, triggered our most recent re-optimisation in December 2022 as the data pointed to the onset of a stagflationary regime (where growth is contracting but inflation remains high). 

However, we see four opportunities based on the outlook for the months ahead:

  • Short-duration fixed income assets are still attractive given high yields. But longer-duration assets should also start to outperform as the prospect of rate cuts appear on the horizon. In general, bond yields and volatility should stop rising – that’s great news for bond investors. (Remember that bond prices and yields are inversely related.)
  • We expect Gold will continue to provide protection during times of uncertainty, as we saw in Q1.
  • In equities, we still think defensive sectors like healthcare and consumer staples are more likely to outperform the broader market as investors look to safer assets. 
  • Diverging economic cycles between DMs and EMs like China, and a more range-bound USD, present a good diversification opportunity – which is why we’ve retained a market weight to EMs in our portfolios.

A long-term investing strategy is still the best approach to withstand near-term headwinds 

Shifting economic cycles are part and parcel of investing, but taking a long-term, globally-diversified approach to investing can help you achieve your financial goals – and keep your cool when markets are shaky. 

StashAway’s portfolios are built on that principle, and are optimised for the prevailing macroeconomic climate. 

Our General Investing portfolios are currently positioned defensively to face market headwinds. In December, our re-optimisation increased exposure to short-duration US Treasuries and maintained their allocation to Gold, which has demonstrably helped our portfolios weather market turmoil to post positive returns in Q1 with lower volatility.

If you’re looking to add ultra-defensive assets in USD, short-duration US Treasuries through our Flexible Portfolios can provide the necessary exposure.

While a long-term investing strategy is key to building your wealth, having access to the right amount of cash in local currency is also important. Our no-lockup, low-risk cash management portfolio, StashAway Simple™, currently has a projected return of 4.1% p.a., and hasn’t seen a week of negative returns since inception.


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