Balancing hawkish central banks against resilient economic growth

Since the start of the Iran conflict, bond markets have been taking their cue from oil prices. As shown in Exhibit 1, bond yields show positive beta to oil price changes with varying degrees of sensitivity. We see this as a direct reflection of the hawkish lean of central banks in the face of the current energy shock. Here, we discuss how our multi-asset portfolios are balancing more hawkish central banks and higher inflation risk against resilient economic growth and exceptional corporate earnings.

In line with the 50% year-to-date rise in oil prices, markets quickly and sharply repriced policy rate expectations. Since February, market pricing for Federal Reserve (Fed) policy rose from 60bps of cuts to over 30bps of hikes. Over the same period, pricing for European Central Bank (ECB) policy moved from unchanged rates to over 40 basis points (bps) of hikes (Exhibit 2). At the same time, bond yields rose sharply, with yields on the 10-year U.S. Treasury (UST) rising over 60bps, lifting yields back to their 12-month highs.

Why are central banks turning hawkish?

Central banks are conscious that inflation has been stubbornly above the 2% target for the better part of the last five years. To maintain their credibility in fighting inflation, in aggregate central banks are reacting hawkishly. The inflation spike of 2022 remains in the collective memory of central bankers and consumers alike. The lesson for central bankers: Act more proactively. Central bankers know, too, that economic growth has held up remarkably well in the face of this year’s energy shock, calling into question how restrictive monetary policy really is.

A range of global central bank response

While the bond market moves were sharp, they were not uniform, reflecting different central bank reactions to the shock. We note three major groupings among central banks: On the hawkish end of the spectrum, the ECB chose pre-emptive policy tightening as its sole mandate targets inflation. Since March, the ECB delivered a rate hike and signalled further hikes, aiming to take policy rates from the lower end of neutral to a more restrictive stance.

In contrast, in the second group, the Federal Open Market Committee (FOMC) has kept rates on hold for the past five meetings, looking through the energy shock and acknowledging that Fed policy is slightly more restrictive than the ECB’s. As a dual mandate central bank, the Fed considers the employment outlook alongside its core inflation focus. Although rhetoric from some FOMC members has turned more hawkish, they have so far taken no policy action. That could change if the Iran conflict enters a new phase of prolonged escalation and it becomes more difficult for central bankers to look through the conflict’s upside risk to inflation.

In the third group of central bankers is the Bank of Japan (BoJ), which is on its own idiosyncratic path. It was gradually hiking rates before the Iran conflict and continues to do so, while still describing financial conditions as accommodative. We question whether Japan’s central bank can increase the pace of hikes from once every six months to once a quarter. But broadly the BoJ has not veered from its pre-conflict trajectory of tightening.

In our view, markets have absorbed most of the hawkish impulse expressed by central banks in recent months. On a forward-looking basis, we believe markets have priced in more tightening than economic conditions will warrant (in our base case scenario). We could see one more rate hike from the ECB, we expect the Fed to remain on hold, and we anticipate further gradual tightening from the BoJ. But we do not expect a full global tightening cycle.

What does this hawkish central bank outlook mean for asset allocation?

Seeing a hawkish turn from central banks globally, investors would in normal circumstances restrain their appetite for risk. We take a different approach in the current environment. We see the rise in interest rates as confirmation of a resilient economy driven by strengthening investment in artificial intelligence (AI) and fiscal support that sustains strong consumption. This varies by region, but broadly the global economy has proved more resilient to higher oil prices that we had expected earlier this year.

This differentiated central bank response to the Iran conflict is creating opportunities for us to lean into regional views in both equity and fixed income markets. We see the higher financing costs coming from ECB rate hikes weighing disproportionately more on the growth outlook in the euro area. We thus favor owning duration in the euro area and are neutral on Europe’s equity markets.

Our base case calls for unchanged policy rates in the U.S. over a 12-month window, which would allow for sustained and strong growth momentum. We expect 10-year UST yields to trade in a 4.2%-4.75% range, with risks to the higher side given the strong growth momentum. In the U.S, we are more acutely aware of inflation upside risks and as such see reduced portfolio diversification benefits from holding U.S. duration (Exhibit 3).

Amidst the Iran conflict, the U.S. dollar has regained some of its safe-haven support, with the DXY up over 2% since February. The dollar’s diversification benefits have improved, strengthening its value in portfolios (Exhibit 4). The U.S.’s position as a net energy exporter, along with attractive carry, further supports the dollar. However, we expect the USD to remain range bound in the coming months. Rate hikes outside the U.S. could close rate differentials, further intervention in the yen could reduce support for USD, and Europe and Japan may sell U.S. assets to fund domestic spending.

A range of factors - acceleration in AI capital investment, domestic spending on defense, energy independence, supply chain resiliency, and consumer fiscal stimulus from tax refunds - suggests that the U.S. economy can continue to grow despite the higher bond yields. These factors also reaffirm our view of the U.S. as a key preferred equity market.

Overall, the hawkish repricing from central banks does not change our pro-risk stance in portfolios, which includes overweights in equities and credit. Strong underlying corporate fundamentals alongside high all-in yields support high yield returns, particularly for our income-orientated portfolios. We opt for a selective approach in equities, preferring the U.S, emerging markets, and Japan, where higher AI capex spending helps bolster returns despite the higher interest rate environment.

As we have noted, the recent rise in yields and central bank tightening have reduced the portfolio diversification benefits of government bonds. For this reason, we maintain moderately sized exposure to risk assets, despite our high conviction in strong economic growth momentum. We would want to see more stability in bond markets and greater visibility on the inflation risks before we would look to increase our risk asset exposure.

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