Although central bank rhetoric and actions remain the key driver for markets at the moment, investors need to consider the risk that financial conditions tighten aggressively to the point that the narrative shifts from inflation to recession.
Given that such a scenario is not currently discounted in asset prices, income and diversification should remain high on every investor’s agenda.
“Long duration assets can play an important role in investors’ portfolios, both as a source of income and as a diversifier to cushion returns against the volatility that we expect in the months ahead,” said Steve Ellis, global chief investment officer, fixed income, at Fidelity.
A careful catch-up
While the Fed recently delivered and tightened policy by 50bp, its most aggressive move in 22 years, with other central banks following suit, the Fed committed a policy mistake last year by letting inflation run out of control, according to Fidelity.
“Policymakers are catching up after being caught behind the curve. But they need to thread carefully, as they walk on a very narrow path,” explained Ellis.
To date, markets have been relatively optimistic, giving the Fed the benefit of the doubt by pricing in a soft landing with rate hikes having only a limited impact on growth.
However, based on what Fidelity describes as the historical experience of the Fed finding it difficult to engineer a soft landing, the firm’s own in-house aggregate recession model suggests just under 15% probability within the next two quarters.
A turn in the tide like this would inevitably lead to a significant repricing of risky. “Credit spreads would not be immune, and we are defensively positioned,” said Ellis.
Selective bond buying
Against this backdrop, on a relative basis, Fidelity sees value – and a reasonable amount of risk premium – priced into areas such as investment grade assets, with all-in yields that look quite attractive now.
On the other hand, it is treading carefully in the higher beta segments of the market such as high yield and emerging market debt.
“Diversification remains essential, and we retain a constructive view on duration after the recent rise in government bond yields,” added Ellis.
“With 10-year US yields now above 3%, and a further 250bp of Fed rate hikes priced over the next 12 months, markets have already priced in significantly tighter monetary policy ahead,” he explained.
