In November, and following the strong rally in US equities, we moved to a neutral position in international equities. We then established a small underweight position in early December, taking advantage of the recent market strength to reduce risk given the global economic outlook remains tilted to the downside.
Elsewhere we retain our neutral position in international fixed interest, having scaled back our underweight position during the quarter, and we maintain a slight overweight to New Zealand bonds.
Although inflation in many parts of the world is trending in the right direction, central banks appear committed to moving interest rates into restrictive territory – and holding them there for a period of time – to ensure inflation does not become entrenched. This will likely weigh on economic activity going forward.
In fact, we are starting to see evidence that the cumulative effect of the monetary tightening over the past 12 months has begun to slow the global economy. Housing markets in developed countries are falling as mortgage rates increase, while business activity continues to slow (with Purchasing Managers’ Index data hovering in the high forties).
In New Zealand, the fundamental outlook is deteriorating fast with evidence the RBNZ will hike the economy into a recession within the coming 12-18 months. While a slowdown in the economy will likely bring inflation down, it will have some unwanted consequences – notably a higher unemployment rate.
Wrapping all this up, our base case is that central banks will keep policy rates in restrictive territory until they are satisfied that inflation will return to target levels, which will no doubt weigh on the global economy as we head into 2023.
Although we expect further interest rate hikes from central banks, 10-year yields should oscillate around 2022 highs, with downward pressure coming from a combination of the pace of the move we have already seen and uncertainty around growth.
The big risk remains persistent inflation, which would put further pressure on financial conditions, increasing the probability of a global recession. The monetary policy tightening that has occurred to date also has the potential to tip the economy into a recession, although the consensus view is that any recession would most likely be mild.