Investing amid aggressive central banks and fragile markets

Against a backdrop of fresh weakness in risk assets as central banks try to tame rampant inflation, alongside another lurch higher in government bond yields, we dedicated our latest CIO call on Wednesday to discussing what the shifting macro environment means for investors.

Joining me were Ed Wicks (pictured above, lower left), our Head of Trading, and Guy Whitby-Smith (lower right), our Head of Solutions Portfolio Management.

I summarise the key points below – but you can listen to the call in full on LGIM’s podcast channel on Apple, AudioBoom, Spotify and our website.

Macro uncertainty

Markets are rattled by rising and broad-based inflation. Consumer price indices continue to hit new highs, dashing expectations by some investors for a peak in the first half of this year, with the rise driven by areas beyond supply-chain disruption and energy prices.

For example, the US consumer price index rose 8.6% in May versus a year ago – its highest level since December 1981 – surpassing market expectations. Core inflation, which excludes food and energy, rose 6%.

Major developed market central bankers, as a result, are taking an increasingly aggressive approach to policy tightening. This, in turn, is stoking uncertainty among investors, given the potential for further data surprises. What’s more, as there’s a lag between monetary policy moves and their impact on the real economy, rates may need to rise further than is currently anticipated.

Fears of a recession are building in light of these dynamics, with Europe at greater risk the longer the conflict in Ukraine continues, while investors are growing more sceptical of the chances for an economic soft landing in the US.

Dipping liquidity

Perhaps unsurprisingly, liquidity across asset classes has dipped, with a reduction in market depth. LGIM’s trading team is seeing signs of stress in some bid-offer spreads, such as in fixed-income markets, while dealers are taking a little longer on requests for quotes.

That said, these factors have only had a modest impact on transaction costs – something we monitor extremely closely.

Our traders are navigating these conditions by utilising technology, not least automation; relationships with our core counterparties; and LGIM’s scale, which enables us to find efficiencies like “crossing” trades.

Within our money market strategies, we favour tilting allocations towards variable-rate notes and remaining highly liquid in the front end.

Accelerating change

This fast-changing environment clearly presents material threats to investors, as the negative returns on most asset classes year-to-date attest – and given the chance of further downside in the near term. But we also see opportunities for long-term investors.

While navigating the risks, pension schemes also have a chance to “harvest” some of the volatility, given the shift in buy-out pricing, wider credit spreads and higher gilt/linker yields.

In the broader adjustment process currently underway, some markets may overshoot their fundamentals, ultimately offering value to a broader set of investors. And we continue to believe that the pandemic and the recent geopolitical rupture have accelerated some long-term investment themes.

More broadly, at LGIM we seek to remain both humble and nimble in navigating this investment landscape in order to meet our clients’ long-term objectives.