Risk barometers

The changing structure after the Ukraine war and the global financial tightening campaign. The war in Ukraine and the standoff with Russia eliminated 40% of the EU's gas supply, exacerbating the inflation crisis and triggering a serious energy crisis in most of Europe. The rise in gas prices alone is putting a burden of up to 8% of GDP on European households and firms. European gas prices peaked at twice that of Asia and 10 times that of the United States. This price shock is likely to trigger a recession, but it will also lead to structural changes in the European economy that put pressure on growth for many years.

It can be argued that governments can be more effective in fighting inflation than central banks. They can invest and lift regulations to increase energy supply and clog supply chains, but they can also reduce demand by encouraging industrial adaptation. Many are moving to conserve supply by guaranteeing loans or nationalizing critical energy infrastructure, while also supporting demand with tax breaks and subsidies. Financial measures related to the crisis in the EU currently amount to 3-4% of GDP and are expanding rapidly. While direct interventions in energy prices reduce measured inflation rates by 3 percentage points, some measures cause inflation elsewhere or in the future.

The data-driven monetary policy of the Fed. Data released Wednesday showed that wholesale prices accelerated faster than expected in September and increased by 0.4% month-on-month, showing that the tighter monetary policy has not yet had a significant impact on the pace of producer price increases. The closely watched consumer price index also increased by 0.4% in September from a 0.1% increase in the previous month.

There was reason for optimism in the producer price index report; that is, core prices, which exclude the volatile food and energy sectors, slowed slightly from the 0.4% increase in August to the 0.3% increase in September. Core consumer prices, on the other hand, continue to increase rapidly on a monthly basis.

Rate hikes and inflation. According to CME data, investors are currently pricing in a 100% probability that the Fed will raise interest rates by 75 basis points, or three-quarters of a percent.

The latest inflation data comes just days after the September jobs report showed a US labor market that has remained quite resilient despite starting to slow from its post-pandemic peak. While there is some evidence of slowing labor demand, as evidenced by the sharp drop in job deficits, US employers still created another 263,000 jobs last month and unemployment fell to its lowest level in more than 50 years.

At the same time, new survey data released by the New York Fed show that consumers' inflation expectations over the three- and five-year timeframe rose slightly in September. This is a warning sign that American households may begin to expect higher prices to continue in the long run; It's a shift that could affect consumer behavior in ways that make the Fed's task of bringing inflation back even more difficult.

-Supply-side shock

The impact of the current conflict appears to be more intense in goods-producing industries, which reportedly experienced bottlenecks even before the Russian invasion, with an incidence of around 80% among European car companies. Meanwhile, sectors less affected by supply disruptions, such as services, are less likely to raise concerns about the war.

Share of companies talking about the Russia-Ukraine war. Source: Federal Reserve

Firms can set higher prices because demand outstrips supply and workers get higher wages given the low unemployment rate. On the other hand, in recessions, you have low aggregate demand below the potential supply of goods, which, combined with low inflation and even deflation, leads to a slack in the labor and goods markets: prices fall as consumers' spending decreases.

Global inflation protection

-Real estate. Investing in real estate has many advantages. This asset class has intrinsic value and provides consistent income through dividends. It often serves as good inflation protection, as there will always be demand for homes regardless of the economic climate, and as inflation rises, property values ​​and therefore the amount a landlord can charge for rent will rise.

Real estate is a tangible asset, but not liquid. An alternative to consider is real estate investment trusts (REITs), which are more liquid investments and can be bought and sold easily in the markets. REITs are companies that own and operate portfolios of commercial, residential, and industrial properties. By generating income through leases and leases, they often pay higher yields than bonds. Another important advantage is that once prices start to rise, their prices will probably not be affected as much because operating costs will not change substantially. An example of a REIT with extensive exposure to real estate and a low expense ratio is the Vanguard Real Estate ETF (VNQ).

-TIPS. Treasury inflation-protected securities (TIPS) are a type of U.S. Treasury bond designed to increase value to keep up with inflation. They are considered among the safest investments in the world as they are backed by the US federal government.

Bonds are tied to the Consumer Price Index and principal amounts are reset to changes in that index. TIPS pays interest twice a year at a fixed rate applied to the adjusted principal. When there is inflation, the principal rises and when there is deflation, it falls. TIPS has three terms: five-year, 10-year and 30-year.

However, there are a few risks that come with TIPS. They are sensitive to any changes in current interest rates, so you may lose some money if you sell your investment before maturity.

-Buying a bank loan. Some businesses can thrive during inflation when prices rise. For example, banks make more money as interest rates rise and profit from rising loan prices.

Buying top-secured bank loans is a good way to get higher returns while protecting yourself from a price drop if rates start to rise. However, keep in mind that there may be a significant delay until the value of the loans increases as rates increase. An example of such a fund is the Lord Abbett Variable Interest Fund (LFRAX).

 Safe haven: bonds or dollars. As an investment, bonds have never pumped blood like stocks or cryptocurrencies. But looking at 2023, there's a strong reason for leaning into this not-so-cheesy corner of the investment world: Bonds are cheap, ready to pay more interest than ever, and yes, their battered prices will likely rebound.

The bond issue, however, applies mainly to the people selling them. Price declines in 2022 have been steeper than interest rate increases. As bond prices moved in the opposite direction from rates, the Fed's seemingly unending enthusiasm for rate hikes aimed at quelling hyperinflation skewed bond values. The price of the 10-year bond is about 92 cents.

The central bank raises the Federal funds rate, a key tool for controlling short-term yields, and this maneuver is straining the economy, pushing yields up everywhere. The rate hike marks a staggering return from the just above-zero Fed funds the Fed placed amid the pandemic days of early 2020. The policy rate currently sits in the band between 3% and 3.25%.

But there is hope for a break from this punitive rate-raising regime and for a brighter tomorrow for bond prices. Harley Bassman, managing partner of Simplify Asset Management in New York, said: 'We are close to the top with the two-year Treasury yield of 4.22%. The widely anticipated and much anticipated recession in 2023 will limit the Fed's appetite for withdrawal rates much higher.' Bassman adds, “The market thinks they will cut rates next year.” In projections released after the September meeting, the Fed itself expects Fed funds to plateau slightly higher than now, followed by a gradual decline.

Increasing interest rates are your friend here too. A year ago, the 10-year T-grade yield was 1.5%. With an annual inflation rate of 6.2% as of August, this meant holding a 10-year bond cost you 4.7 percentage points. The gap between the 10-year return and the higher 8.3% of the more widely tracked consumer price index was even worse.

But assuming that hyperinflation has receded and interest rates have not dropped that much, this problem may end. The Fed's economic forecasts keep PCE inflation down to 2.8% next year. If so, current yields for 10 years (3.8%) will highlight an investor. 'This will be the worst year for bonds,' Lawrence Gillum, bond strategist at LPL Financial, said in a research paper: “The diversification feature of the bonds has also increased.”

 Conclusion? Historically, periods of heightened geopolitical risks have been associated with significant adverse effects on global economic activity. Wars destroy human and physical capital, shift resources to less efficient uses, divert international trade and capital flows, and disrupt global supply chains. Additionally, shifting perceptions of the diversity of the consequences of adverse geopolitical events may weigh more on economic activity by delaying firms' investments and hiring, eroding consumer confidence and tightening financial conditions.

In this period of economic turmoil, many tools are available to protect individuals and firms from inflation. As we saw above, real estate investment, buying bonds and bank loans are great examples.

“Given how Japanese government bond yields are an anchor for global fixed income, the repercussions of a policy change are likely to reverberate far in global assets,” UBS strategists including Rohan Khanna wrote this week: “Markets most affected by the BOJ policy change will be the markets with the largest footprint of Japanese investors.'

While an imminent policy change isn't on UBS's radar, a team at the bank reviewed the possible implications of a surprise move this week as part of a memo answering 'the toughest customer questions.'

For example, raising the upper bound on the BOJ's hard stance on 10-year yields 'helps erase speculative yen deficits and helps the currency rise to 130 against the dollar,' he said. While not a fundamental scenario, abandoning the BOJ's cap altogether This could see an increase in US mortgage-backed securities yields, outstripping the large JGBs held by Japanese investors.

Conclusion? While most central banks are heading in the same direction, speculation that a country may give up its fight against inflation can fuel hopes that other policymakers will eventually follow suit, and lead to fluctuations in government debt around the world.

The Bank of England intervention is also likely to put additional downward pressure on the sterling, although the moves by Japan and the UK to control bond yields are slightly different. It will also be inflationary. This shows how unattractive the policy options are at the moment.

We also found that controlling the yield curve as Japan did is not a good tool to control the strength of a currency. As a result of Japan's actions, the JPY weakened against the USD.

Kaynak: Tera Yatırım-Enver Erkan
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