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Macro uncertainty calls for agility and diversification

As part of a new initiative, FSA is talking to market participants about key trends that shape fund selection. This week, Sushil Wadhwani, chief investment officer at PGIM Wadhwani, discusses the role of macro strategies within a portfolio.
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Global markets have taken a beating during most of 2022. Lingering supply chain issues, exacerbated by the war in Ukraine and pandemic-induced shutdowns in China, helped push global inflation significantly higher. As central banks tightened monetary policy in response, fears of recession gripped markets, with stocks, bonds, and real estate assets declining sharply throughout most of the year. Meanwhile, commodities generally rallied, although returns among individual commodities were somewhat divergent.

With central banks around the world enacting restrictive monetary policies to rein in inflation, we highlight four macroeconomic scenarios most likely to occur, depending on future moves of the US Fed:

1. A “soft landing” in which the Fed’s forecasts turn out to be broadly correct, with inflation gradually dropping back to target, but without unemployment rising by that much and with a recession being avoided.

2. Persistent inflation and recession in which inflation turns out to be more stubborn than expected and the Fed is forced to tighten by more than is priced in and/or keep rates high for longer, thereby eventually leading to a recession.

3. The Fed tolerates higher inflation in which the Fed tightens to bring inflation down from current levels but is unwilling to take risks with respect to a recession or financial stability and so pauses before it has done enough to bring inflation down back to target.

4. A “hard landing” in which the tightening in financial conditions that has already come about leads to a recession, and perhaps quite quickly, and thus the Fed may end up tightening less than is currently priced in.

For much of the year, investor expectations generally aligned with a greater likelihood of scenario two transpiring—i.e., persistent inflation followed by recession—in part because the extent of the rise in unemployment projected by the Fed had been associated with past recessions.

As other central banks signalled or slowed the pace of rate increases in October, investors turned bullish, anticipating that the Fed, too, would move to a less aggressive stance. Amid this backdrop, the probability of either a “soft landing” (scenario one) or the possibility that the Fed might be willing to implicitly accept a higher inflation target (scenario three) increased, and along with it, equity markets partially recovered prior losses.

Agile Diversification Remains a Priority

With headline inflation likely to have peaked (or to peak soon) in many countries and central banks tightening at a slower pace, investor hopes of a “soft landing” in the US are likely to rise. On the other hand, a slowing global economy is likely to put downward pressure on earnings forecasts. The outlook for equity markets is therefore uncertain. As previously noted, there are concerns that central banks might implicitly tolerate a higher rate of inflation and this could undermine bonds.

It is therefore possible that the traditional 60/40 portfolio may continue to fare poorly. An agile global macro strategy can isolate diverse and less correlated sources of returns by factoring in regime shifts and profound changes in sentiment or expectations. The ability to go both long and short in various asset classes is an additional advantage, providing flexibility to react nimbly as conditions shift. Global macro has delivered strong absolute returns and relative returns versus stocks, bonds and real estate this year, making it an attractive portfolio diversifier and alternate return source through rising rates and inflation.

Sushil Wadhwani is chief investment officer at PGIM Wadhwani.

Part of Mark Allen.