Rising interest rates, inflation, possible recession – a market assessment

Until recently, TINA (“there is no alternative”) had prevailed, but that changed with the interest rate turnaround in 2022. TINA has now given way to TARA (“there are reasonable alternatives”). Markets are more balanced, albeit more volatile, and current market prices reflect economic fundamentals better than two years ago. This allows resources to be allocated more efficiently and investors to make more rational decisions.

After the long period of negative interest rates, higher interest rates and credit spreads have led to a revival of fixed income. However, it is clear that last year’s abrupt monetary policy tightening initially had a dramatic impact on bond investors. For example, US government bonds had the lowest yield since the late 1970s. In the meantime, the situation has become much brighter again, and an end to the interest rate turnaround is in sight. Accordingly, earnings in many bond segments have also been positive since the beginning of 2023, particularly for bonds in Swiss francs. This is likely to remain so for the rest of the year, especially in the higher-quality segments.

A similar trend can be seen for equities. The bond-equity relationship should also make it possible to manage portfolio risk again. Many investors assume that there is a negative correlation between bonds and equities. In fact, the fair price for both is determined by discounted cash flows. The main difference is that bonds tend to have fixed cash flows, while equities have variable cash flows associated with earnings growth. If interest rates rise or fall, both bonds and equities will move in the same direction, all else being equal, i.e. they will correlate positively. However, if the expected income growth changes, the correlation may change its sign. Currently, there is a good chance that bonds will protect investors from a downturn in equities.

Interest rates and inflation influence each other. Central banks have long believed that inflation is a temporary phenomenon. Accordingly, they held back on raising key interest rates. This meant that, eventually, key interest rates had to be hiked sharply and quickly, particularly in the US. As well as the need to combat inflation, the exchange rate often played a role in central banks’ considerations, especially in Switzerland, which is heavily export-oriented.

Due to foreign exchange market interventions, the Swiss National Bank (SNB) has significantly inflated its balance sheet in recent years in order to prevent an excessive strengthening of the Swiss franc. This was long regarded as a problem in expert circles, but today it is proving to be an advantage. Not only is inflation in Switzerland significantly lower than in the rest of Europe and the US, but the SNB is also able to combat an undesirable depreciation of the Swiss franc by actively selling foreign currencies without having to raise interest rates significantly. We therefore expect the SNB to stop raising interest rates and the interest rate difference compared with other countries to remain high in the medium term.

However, over the next five years, we expect inflation rates for Western economies to be around 70 to 100 basis points higher on average than in the ten years prior to the pandemic.

Taking into account the macroeconomic environment, the question of the impact on investment arises. Currently, there are two prevailing views amongst economists: while some believe there will be a soft landing for the US economy, others expect a recession in the coming quarters. Swiss Life Asset Managers tends to take the second view. The current inverse yield curve also supports this scenario. The best leading indicator for a recession is probably consumer credit defaults: in the past, they increased one to two years earlier. As credit defaults have been rising from low levels since October 2021, higher interest rates and tighter credit standards are also expected to exert a further drag on consumption.

In the eurozone, purchasing managers’ indices also point to an increased risk of a recession, especially for the manufacturing sector. In Switzerland, we expect a stagnation of the economy.