Latin America Is Generally On A Decelerating Path
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Growth and inflation outside the United States
Michael, let’s look more globally. What’s your outlook for inflation and growth outside the United States?
Michael: It’s a challenging time because there’s a lot of variance when looking at different parts of the world. In Europe, inflation is currently running higher than in the United States. It is only beginning to peak on the headline inflation numbers, and the core numbers (excluding food and energy) are still in an upward trend, whereas in the United States, both inflation measures have been trending down. It’s a question of how quickly they trend down. Energy was a much bigger factor in Europe, and wage negotiations were a very significant contributor to some of Europe’s inflationary dynamics.
“ The key takeaways looking globally at inflation are that Latin America is generally on a decelerating path, and that Asia is slightly accelerating, but the terminal level will likely be a lot lower than what we witnessed in the United States and what we’re seeing in Europe.” Michael Hasenstab
Asia looks very interesting. The core Tokyo CPI, which comes out a little earlier than the national CPI, rose 4% in December, the highest level since the 1980s. While it does tend to differ from the national reading, it’s an interesting signal in that Japan is seeing some different dynamics. Many investors had written off Japan because for decades it struggled with a deflation liquidity trap. So, I think it is an interesting dynamic and has important implications for growth and for currencies.
If we look at the rest of Asia, we did not see the same magnitude of inflation that we saw in the United States or in Europe. It was a lot more moderate, and lagged, because COVID-related policies greatly restricted the opening of economic activity. While inflation in the United States has been on a clear downtrend in recent months, there are still some moderate upticks in Asia, but the magnitude is different. It’s at much lower levels generally throughout the region. With China beginning to open again, growth dynamics there could have some moderate inflationary impacts, but for good reasons.
In Latin America, some countries saw inflation readings surge earlier and faster than in Europe or the United States—hitting double-digits. It necessitated some very aggressive central bank activity, which did occur. And now in many cases we’ve seen that inflation trajectory change to inflation coming back down. So, the key takeaways looking globally at inflation are that Latin America is generally on a decelerating path, and that Asia is slightly accelerating, but the terminal level will likely be a lot lower than what we witnessed in the United States and what we’re seeing in Europe.
Quality and duration decisions key in “run” toward fixed income
Gene, you’re looking at multi-asset portfolios, trying to make some decisions in terms of positioning. What is your thinking right now?
Gene: The inflation outlook and commensurate policy response, and the equity and bond market reactions to these variables, have largely influenced changes to our asset allocations from 2022 until now. We look at inflation as being both a cause and a symptom of underwhelming market performance in 2022, and it’s really changed the calculus for all risk assets over the past quarter: for equities, fixed income and everything in between. We think the Fed, and most other central banks, have really set the economic context over the past year, given the tightening of rates in response to higher-than-expected inflation. We believe that’s going to continue, and we’ve already seen the negative impact inflation had on equities last year. But perhaps the reset in bond yields has been a stronger force driving allocation shifts.
Consequently, bonds overall offer a much more favorable risk and return tradeoff against equities than we’ve seen at any point in recent memory. We characterize this asset allocation preference as not so much about running away from equities, but rather, running toward fixed income. Last year it was challenging to eke out return from fixed income, and it was a pretty disastrous year in terms of portfolio-level returns.
So far, that’s not looking to be the case this year. Over the last couple of quarters, we have shifted our strategies from being at one point overweight equities to now overweight fixed income, as equities continue to track the economy and resulting policy response. As I mentioned, we believe a recession is ultimately looming on the horizon and we are monitoring the situation very closely. Should “recession” go from concern to reality, this will likely have profound implications on asset allocation, and not just at a high level between equity and fixed income, but also within equity and fixed income sectors.
Sonal, Gene mentioned that from an asset allocation point of view, he’s “running toward fixed income.” Can you share your thoughts on duration and where you think there are opportunities now within fixed income?
Sonal: Historically, I’ve always been pretty pessimistic about the outlook for fixed income, but I do think this is a great point in fixed income—that I completely agree with Gene on. Markets have recently seen huge daily swings in basis points, so it makes abundant sense to shorten your duration, but you have to do it tactically. If you can be tactical, I’d say it’s a good time to be invested relatively short to benchmark indexes because I have very little doubt that we’re going to see selloffs, we’re going to see the market react to the Fed, perhaps to actions out of Japan.
We’ve had a strong start for fixed income in the first three weeks of this year, which in my view, makes it an excellent time to actually stay a bit short duration because that’s not going to last. Having said this, the areas where I am most bullish would be investment grade, which seems fairly boring but offers good yields currently around 4%–5%. This implies some duration, but is an area that should be able to weather a mild recession. I’m also looking at high-yield credit, which in an absolute way is delivering much higher yields. There will be volatility, but if you can ride out the next 18 to 24 months and are very selective, I think it’s an excellent time to enter the market. Over the past several years, investors had to go to the alternatives space, or private credit to see the types of returns that we are currently getting in liquid public markets on the fixed income side. I would reiterate that it’s great time to be an active investor, because you want to try to avoid those pockets of extreme weakness. At this point, I’d be a little more hesitant in the floating-rate space, because you have to be extremely careful with interest rates continuing to go up.
Lastly, emerging markets are looking at decent fundamentals, and fabulous valuations in terms of starting points in hard currency as well as local currency. I think the US dollar probably has gotten pretty much toward its topmost level, especially as we continue to see changes from Japan. I think this sets us up nicely in the emerging markets space.
