Navigating uncertainty in a shifting economic landscape
During the December Investment Committee meeting, the team discussed the difficulties they have faced since the US Federal Reserve stopped providing guidance on monetary policy. This has made markets uncertain about the future path of US interest rates and has led to higher volatility across markets.
The committee expects this to continue in the next year in an uncertain economic environment focused primarily on inflation data and policy response.
Higher interest rates do not necessarily lead to lower inflation
It is important to clarify that Interest rates and inflation are two separate economic concepts, and while they are related, they do not have a direct cause-and-effect relationship. There are many factors that can affect inflation, and higher interest rates alone do not guarantee that inflation will decrease. More specifically:
The global economy is shifting toward a new equilibrium where surges in demand will lead more frequently to higher prices
The post-pandemic economy's high inflationary pressures are being driven by secular trends on the supply side
In the past, supply expansion dominated demand surges, creating deflationary conditions, but this is changing as we emerge from a long period of deflationary conditions.
Softer inflation data and risks of reigniting inflation
Inflation may have moderated since June 2022, but it remains significantly higher than the current Fed fund rate. If the central bank stops hiking rates too early, there is a risk that inflation will reignite. If we take into account the possibility that inflation will remain elevated for structural reasons, there is a non-negligible risk of another downturn in risky markets.
However, our main scenario is that if the Federal Reserve persists in hiking interest rates, demand will be sufficient to curb inflation.
Mathematically, annual CPI will continue to rise even after headline inflation has peaked. Therefore, long-term bond yields lower than, for example, 4% do not sufficiently compensate for the average inflation rate, which is likely to rise above 3% over the next few quarters. It is far more probable, then, that any damage is only halfway done, and that we have not yet seen the bottom.
The good news is that valuations are becoming more aligned with long-term averages, and expected returns will be higher as equity prices become low enough to compensate for the extra risk compared to bonds.
Portfolio approach
The committee remains cautious going forward and suggests investors should choose a diversified mix of yield-generating investments and avoid holding excessive amounts of cash. They advise increasing the allocation to government and high quality corporate bonds, as well as considering alternative investments like absolute-return solutions offered through KM Cube’s platform.
Finally, the committee believes that a value-oriented equity portfolio will be the most important factor for portfolio outperformance, and that this approach is likely to continue in the coming years.
Authors: John Couletsis and Kostas Metaxas