Growth outlooks throughout the region have plummeted amid soaring energy prices. The energy sector has a huge impact on the inflation rate in Europe. And as an added challenge, Russia is the leading energy supplier to the region.
Record inflation and growing stagflation concerns recently prompted the dovish ECB to take a surprising turn. Policymakers now plan to end their bond-buying program in the third quarter rather than the fourth, and they may raise rates later in the year.
The Bank of England already has lifted interest rates twice, as the country deals with its highest inflation rate in 30 years. And it’s likely U.K. policymakers will raise rates again when they meet this week. Elsewhere, the Bank of Canada increased its key lending rate in early March, marking its first rate hike since October 2018.
Q. Other factors over which the Fed has no control—broad supply/demand imbalances, skyrocketing oil prices, rising housing and food costs—are also pushing inflation higher. Will these influences overwhelm the effects of the Fed’s tightening?
A. The current episode of rising inflation is a result of several years of excessively loose financial conditions combined with recent supply shocks. While the COVID pandemic initially triggered the supply shocks, geopolitical tensions are now further aggravating the situation.
Indeed, the inflation backdrop is complex and intertwined with short-term and structural dynamics, some of which are clearly outside the Fed’s control. As such, the Fed’s tightening measures, while necessary, may be insufficient to bring down inflation by themselves.
Therefore, we believe inflation could stay much higher than the Fed’s 2% target for an extended period. And this could pose a serious risk to the economy and financial markets.
Q. When do you expect inflation to ease?
A. Russia’s invasion of Ukraine has introduced a new and complicated dynamic for global markets and inflation. We expect the conflict to further disrupt supply chains and keep prices elevated for a variety of goods.
Our best-case scenario calls for inflation to start moderating later this year. But we don’t expect a rapid or significant decline. In our view, inflation will remain well above pre-pandemic levels until:
- Supply dynamics improve in the energy commodities sectors, labor markets and manufacturing.
- Demand trends slow down or contract.
- Real rates (rates adjusted for inflation) turn positive.
In my view, we won’t see these preconditions emerge for quite some time.
Q. With rates on the rise and inflation high, should investors still hold bonds?
A. Despite the rate backdrop, we still believe bonds have an important place in diversified portfolios. While periods of rising rates and inflation can be challenging for bond investors, it’s important to remember why you own bonds in the first place. Bonds have the potential to provide a steady stream of income and may help limit the effects of stock market volatility.
Rising rates and higher inflation tend to pressure longer-maturity Treasuries and other high-quality bonds. But shorter-duration bonds typically have less price sensitivity to rising rates. For more context, please see “How Bond Investors Can Combat Rising Interest Rates, Higher Inflation.”
Additionally, floating-rate securities, such as bank loans, floating-rate corporate bonds, collateralized loan obligations and others generally have little exposure to interest rate risks. They also typically offer more attractive yields than government securities, but with varying degrees of credit risks. Investors need to carefully manage those risks.
Treasury inflation-protected securities (TIPS) offer an alternative for investors concerned about inflation. The value of TIPS adjusts along with inflation.
As inflation rises, the principal value of the security increases, creating a steadily growing stream of interest payments. At maturity, the TIPS owner receives the original principal value plus the sum of all the inflation adjustments. Of course, in periods of broad price declines, the opposite occurs and the value of TIPS declines.
Overall, bonds may decline in value during the early months of a rate-hike cycle. However, as interest rates increase, investors can reinvest the proceeds from coupon payments and maturing bonds at higher interest rates. Over time, this may improve returns.
In these challenging markets, an actively managed bond portfolio with shorter-duration and carefully selected floating-rate securities may enhance returns and offer downside protection.
Q. What do higher rates mean for stocks?
A. Higher interest rates can create challenges for stock investors, too. They raise interest expenses for companies that rely on debt financing, and they increase the cost of borrowing to fund new projects or expansion.
As my colleagues on the equity side have observed, rising interest rates generally present a greater obstacle for growth stocks than value stocks. Higher rates increase the appeal of current income, including bond payouts and stock dividends. At the same time, though, higher rates decrease the value of future cash flows. This is key, our equity team concludes because investors mostly look to future cash flows when valuing growth stocks.
Some value-oriented stocks, such as those in the banking sector, may benefit from rate hikes, according to our equity managers. Fed rate hikes typically push consumer loan and mortgage rates higher. For banks, this may mean increased revenue.
Our stock managers also note that higher rates often increase the appeal of dividend-paying stocks. While issuers of growth stocks often hang onto their cash to reinvest in the business, dividend-focused companies take a different approach. For example, utility companies and real estate investment trusts have routinely paid out large portions of their cashflows to shareholders.
Q. Will the Fed’s action affect mortgage rates?
A. The Fed doesn’t set mortgage rates, but its decisions about rates can indirectly affect mortgage rates and directly affect other rates. When the Fed hikes the federal funds rate target, rates on credit cards, adjustable-rate mortgages and other shorter-term loans generally rise. On a positive note, interest rates on savings, CD and money market accounts also go up.
Conventional fixed-rate mortgages tend to track the 10-year U.S. Treasury note more than the federal funds rate. Fed action doesn’t directly influence the 10-year Treasury yield, but it usually has an impact.
The Fed typically raises rates to slow an overheating economy or, as it’s doing today, to temper inflation. Rising inflation pushes longer-maturity Treasury yields higher, which causes mortgage rates to rise. This is a big reason why mortgage rates started heading higher late last year.
The Fed has a more direct influence on mortgage rates when it’s buying or selling bonds. In times of financial stress, such as the start of the pandemic, the Fed has purchased bonds to support market stability. This buying, which included mortgage-backed bonds and Treasuries, helped push mortgage rates to record lows.
The Fed stopped buying bonds earlier this month. And policymakers have indicated they will start reducing the Fed’s bond portfolio later this year. These steps will likely cause Treasury yields and mortgage rates to climb higher.
Q. How should investors respond to the current market environment?
A. Although the Fed’s rate hike was no surprise, it came amid extraordinary domestic and global circumstances. We’re facing an historic backdrop of war, soaring consumer prices, broken supply chains, rising interest rates and slowing economic growth. And while this combination of factors is unusual, the resulting market volatility is not.
As always, we encourage investors to remain disciplined and avoid reacting to short-term market swings. In our view, investing across multiple asset classes and sectors with a focus on downside protection is a prudent approach in the current market environment.
Additionally, it’s important to remember that market dislocations often create opportunities. We suggest investing with experienced professionals who have the insights, conviction and discipline to recognize and potentially capitalize on attractive opportunities when they’re significantly undervalued.