Amid higher interest rates and lower spending, real returns may prove elusive

IT has been a rather eventful and dramatic year so far in financial markets. Although equity markets have rebounded significantly from their lows in the past two weeks, global equity markets are still down year to date.

European equities are among the worst performing equity markets, declining by 9 per cent year to date, given their higher vulnerability to the growth slowdown and other risks from the war in Ukraine.

Over the past 80 years, the median sell-off in approximately 30 geopolitical and domestic US political events was around 5-7 per cent over a 3-week period, and markets generally recover their losses over the following 3 weeks.

The US and European markets seem to be following that same pattern this year with markets having recouped most of their losses since the war started.

However, where the market is vulnerable is in energy prices given the much higher base of inflation globally - and, therefore, the higher possibility of a recession risk via commodity price shocks transmitted through higher interest rates.

Elevated commodity prices raise recession risk by reducing real incomes and constraining the ability of policymakers to respond to negative growth shocks.

As reflected by the meagre increase in consumer spending of 0.2 per cent in February, US consumer spending is starting to show signs of weakness.

The multi-decade high in inflation is starting to hurt disposable incomes as US median home prices have risen to US$420,000 and 30-year fixed mortgage rates have risen to 4.7 per cent.

Petrol prices in the US have also increased by 45 per cent this year to top US$4 per gallon.

Higher petrol prices and mortgage rates act like a tax on the US consumer, affecting disposable incomes. To a certain extent, this has been mitigated by the strong payroll and wage gains in the current cycle; in March, US wages increased 5.6 per cent year on year.

At this stage, the impact on spending on durable goods and services has been marginal. We have reflected that by marginally reducing our estimates for global tech earnings this year to between 12 and 13 per cent, down from 14 to 15 per cent previously, on the back of lower consumer tech spending.

The other major factor affecting market sentiment over the next few months is the US Federal Reserve's expeditious move to normalise monetary policy amid rising stagflation risk.

Based on UBS's forecast, the target rate should increase by at least 5 times this year, resulting in an average rate of 2.25 per cent by the end of this year.

While the hikes might seem excessive in a year, the terminal rate of 2.25 per cent is tame, compared to the longer-term average. Since 1960, the Fed funds rate has averaged 4.8 per cent, with the real rate averaging around 1.6 per cent.

Even from the period of the so-called "Great Moderation" of the late 1980s, the Fed funds rate averaged 2.7 per cent and the real rate averaged 0.7 per cent. We are well below those levels today.

What should the appropriate Fed funds rate be? The Taylor Rule is a framework for determining the appropriate funds rate based on the values of inflation and economic slack such as the output gap or unemployment gap. Using the prescribed formula, the Taylor Rule implies a Fed funds rate of 9.8 per cent today, well above our forecasted terminal rate of 2.25 per cent.

With the Fed raising rates and the yield curve flattening, it is no surprise that recessionary concerns are on the rise. Much attention has been paid to the inversion of the yield curve as expressed by the 2-year US Treasury and the 10-year US Treasury yields, which in previous business cycles have often been a clear signal of recession risk.

However, I would argue that nominal curve inversion is not that unusual in environments of high inflation like today, which require only a modest flattening of the real yield curve to see the nominal curve invert.

Furthermore, the Fed worked to compress the term premium directly through quantitative easing in the post-global financial crisis world. This strategy worked effectively, easing financial conditions and lifting growth momentum, thereby leading to an inverse relationship between the term premium slope and growth expectations.

For this reason, empirically, the yield curve's reliability as a recession indicator is likely compromised.

Despite the recent move in higher global government bond yields as result of the start of the Fed's hiking cycle, the percentage of bonds with a higher yield than inflation is still miniscule. In a post-Covid world of enormous government debt, financial repression and structurally higher inflation, positive real returns are likely to remain elusive.

With the Fed embarking on a multi-year rate hike cycle, average global non-bank institutional bond allocations have fallen to just 18 per cent, the lowest level since the global financial crisis. The stress and volatility in the global bonds market will likely continue and we can't rely on the Fed's "put" option coming to the rescue as that will likely be replaced by a "call" option, with quantitative tightening around the corner.

As such, investors will need to diversify their portfolios. Strategic asset allocation accounts for as much as 80 per cent of a portfolio's returns. In a year where high inflation, rate hikes and geopolitical risks will likely continue to dominate headlines, the need for diversification has never been clearer.

The writer is regional CIO, UBS Global Wealth Management.