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Uncertainty Clouds the Outlook

An anti-goldilocks economy refers to the global economy where policymakers are confronted with a stagflationary supply shock, which is negative for growth and will tend to push up inflation further. In the current market condition, inflation is “too hot,” as evidenced by the higher energy and food prices, as well as the disrupted supply chains and trade. Globally speaking, energy and food prices have been increasing significantly since late April of 2020, while supply chains and trade flows have been lowering since May of 2020. On the other hand, economic growth is “too cold,” as indicated by the tighter financial conditions since year-end 2020 and the lower business and consumer confidence due to uncertainty.

Significant uncertainty clouds the outlook; however, the baseline development-market (DM) growth remains above trend, especially in the US, assuming a 1.5% DM real GDP growth. DM inflation, as measured by core CPI inflation, peaks at elevated levels, the target of which was 2%.

The current global markets witness greater divergence and dispersion of outcomes among countries and regions: DM exposure to Russia varies across the US, the UK, and the eurozone. Italy has approximately 21% of all outstanding loans to Russia, accounting for 2.5% of all the foreign claims (FCs) of Italian banks. Austria has nearly 14% of outstanding loans, representing 3.7% of all Australian banks’ FCs. France’s loans are also approximately 21%; however, they are just 0.7% as a share of total FCs. No other European economies have Russian FCs exceeding 0.4% of their totals. The direct impact on European banks’ balance sheets from Russia exposures will be relatively low. On the emerging-market (EM) side, looking at EM commodity exporters and importers, winners and losers are highly divergent, as indicated by the commodity trade balance as a percentage of GDP.

On volatility across equities and rates, although modest in absolute terms, equity volatility, as measured by the VIX index, has increased, especially since May of 2021. Meanwhile, rate volatility, measured by the CBOE interest rate volatility index, has picked up amidst inflation concerns.

Policymakers struggle to balance higher inflation against greater uncertainty. Higher and more broad-based inflation raises the risk that inflation expectations become unanchored. Market expectations for year-end 2022 policy rates are higher across the Fed and the key central banks; however, central banks are unlikely to ride to the rescue, increasing the risk of weaker growth or even a recession. In the US, different indicators imply that it may already be in the late cycle. Elevated inflation will continue to drive rate markets.

A decrease in demand from the Fed has raised mortgage rates and cheapened valuations. As of March 22, 2022, Agency MBS spreads have widened almost 40 basis points (b.p.) since the Fed announced its intention to taper MBS purchases, back to its cheapest levels in two years. Higher rates and wider spreads have caused mortgage rates to rise, likely lowering MBS supply, extending outstanding MBS, and increasing yield potential. As of March of 2022, the conventional 30-year mortgage rate was 4.51%.

Further on credit, spreads have retraced well above their post-pandemic tights. Investment-grade credit indices have largely recovered from the COVID-19 sell-off; however, sector dispersion remains high. The recovery trade in select resilient corporate credits that have ample liquidity, particularly hardest-hit sectors such as travel and leisure, may be poised to outperform and offer further upside to a reopening of the economy.

Lastly, the financials sector, especially banks, benefit from strong balance sheets with an average investment-grade rating, which can deliver attractive yields. As of Feb 28, 2022, the average yield for the European additional Tier 1 market was 561 b.p. and that of the global high yield market was 526 b.p.

In fact, higher rates may prove to be an attractive entry point, as index yields per unit of interest rate risk are historically low. As of Feb 28, 2022, the yield-to-duration ratio of the Bloomberg US Aggregate index was 0.35, and that of the Bloomberg Global Aggregate was 0.24. Dispersed valuations reinforce the importance of active management and selection. In the current market conditions, portfolio flexibility and liquidity are the crucial.


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