This year has been challenging for most investors. High inflation, an increasingly hawkish Federal Reserve and economic uncertainty have weighed on markets. Global equities are in a deep correction, down 17% year-to-date through May 10 measured by the MSCI ACWI index. Equity corrections are common, typically occurring every year or two. What has made this downturn worse is a simultaneous bear market in bonds. The Bloomberg Aggregate Bond Index is down 10%, meaning a broad 60/40 portfolio is down nearly 14% year-to-date. Long duration bond portfolios, which are often favoured by liability-focused defined benefit plans, are down more than 20%.
Monetary Policy has Shifted to a Headwind
Inflation and the outlook for monetary policy is the primary driver of poor performance for bonds and equities. Inflation remains uncomfortably high, and the Russia-Ukraine conflict along with lockdowns in China have added to inflationary pressures. This has made the Fed’s job of returning inflation to target more difficult. At the start of the year, the market was pricing a gradual increase in the Fed Funds rate to 1.6% by the end of 2023. Markets are now pricing an overnight lending rate of nearly 3.25% by the end of next year. This has cascaded into longer-term interest rates with the 10-year bond yield doubling from 1.5% to 3.0%.
This has had a direct negative impact on bond portfolios and has exerted downward pressure on equities. A significant reason why equity valuations were high was that interest rates were so low. The movement in yields has increased the discount rate on equities, lowering valuations. Moreover, the prospect of tighter Fed policy and the Russia-Ukraine conflict has increased economic uncertainty, also weighing on sentiment.
Outlook – Uncertainty Abounds
In Mercer’s view, market behaviour this year is a rational response to the increase in interest rates and the more uncertain outlook for inflation, monetary policy and economic growth. The range of potential outcomes has widened.
Mercer’s base case view is that the monetary policy response priced by markets should be sufficient to curb inflation and that the global economy will avoid a recession over the short term. However, the risk of worse scenarios has increased. Should the Fed tighten prices by markets could prove too much for the heavily-indebted US economy to bear, and inflationary fears could quickly give way to recessionary fears. Conversely, inflationary pressures could become entrenched, requiring the Fed to respond even more forcefully than currently priced by markets. This scenario could end with a recession.
Because of this uncertainty, Mercer does not yet view this correction as providing a good entry point to increase equity or duration exposure. Mercer’s dynamic asset allocation views reflect this. Mercer will continue to monitor market conditions and communicate changes in its views. In the meantime, Mercer reminds clients to focus on the long term. As Bernard Baruch said, “Now is always the hardest time to invest.”