Central banks could unexpectedly put the brakes on fiscal tightening to avoid a global recession, and investors should pay heed, Fidelity International’s global chief investment officer for fixed income Steve Ellis warned today.
The Bank of England, the European Central Bank and the Federal Reserve all recently raised base rates of interest in separate bids to curb rising inflation.
Just last week, the Fed announced it would raise interest rates by 0.75%.
However, Ellis warned of a “real possibility” that major central banks might have to skip their tightening trajectories prematurely to avoid a “fiscal cliff”.
This month, for example, Christine Lagarde unveiled plans to abruptly end the ECB’s more than trillion-euro bond-buying programme, instigated last summer to stimulate the economy, this July.
“Central banks rarely succeed in tightening monetary policy without triggering an economic downturn,” Ellis said, adding that, “at present, markets expect lofty increases of 150-250 basis points in benchmark interest rates in the US, Europe, and the UK over the coming 12 months.”
The Investment manager at Fidelity said in a note to the market today that it is possible “major central banks will have to abandon their tightening trajectories prematurely given the fiscal cliff, powerful base effects, a significant loosening of the labour market, and thawing supply chain issues. And if this is the case, investors should be prepared.”
“The narrative in the market could shift abruptly and wrong-foot investors,” Ellis warned.
Recent tough talk among central banks on inflation could “spell further sell-offs in equities and widening of credit spreads”, said Ellis, adding: “The latest upsizing of the Fed’s hike to 75bp (first time since 1994) is an important development on this front.”
Such measures could put considerable stress on the economy and liquidity is already "draining out of the system” just as the Fed’s quantitative easing is starting, according to Ellis.
He warned of the risk of ‘asset price dislocation’ from the banks’ fiscal tightening policies, where in times of stress assets are priced incorrectly, which Ellis said will likely be “skewed to the downside”.
“In general, as interest rates rise the price of a bond will fall,” according to Fidelity's fixed income monthly report for June, which cautioned of the risk of corporate defaults and said sub-investment grade bonds are particularly risky.
Credit markets are meanwhile “under-pricing corporate defaults”, according to Ellis, and these default prices could rapidly increase if a recession was on the cards.
“The one-year implied default risk for USD high yield is approximately 2.5% - this seems far too optimistic in a rising rate and slowing growth backdrop,” Ellis said.
The news isn’t all bad for investors, however.
Fidelity's monthly update showed that default rates remain “low” and that for the most part company earnings have not been badly hit, with many companies trading on “upbeat” valuations.
Ellis said it could make sense for investors to respond to current market conditions by gradually increasing exposure to US Treasuries. The last rally in US Treasuries happened in anticipation of the rate hike in May.
“Capital preservation in a climate of heightened uncertainty is essential, however, when monetary policy and the market narrative change eventually, there could be exceptional returns available,” he said.