Inflation benefits fixed-income investments

Looking back at 2022: The origins of the recent inflation

The past three years in the financial markets have been significantly more turbulent than the preceding years. Shocks like COVID-19 and the energy crisis, which was caused by the war in Ukraine, have resulted in significant uncertainty. Inflation took root early as a result of the pandemic, which was officially declared on March 11, 2020. Lockdown led to an increased need for consumer goods, but production couldn’t keep up with demand. However, the global economy recovered surprisingly quickly after the pandemic, thanks in part to fiscal and monetary support. The recovery also led to increased demand for goods. The result of this was increased production, increased demand for raw materials, and increased prices. Global supply chain problems, such as production breakdowns in China, made the situation even worse.

With the war in Ukraine starting on February 24, 2022, and the resulting economic consequences (higher prices, especially in the energy sector), global inflation reached levels that hadn’t been seen for a long time. Inflation in Switzerland increased by more than 3% in summer 2022 but is still far lower than inflation in the US and Germany.

Price increases fight inflation

Ultimately, inflation has increased beyond the target range since 2022. This caused the US central bank (the Federal Reserve), the European Central Bank (ECB), and the Swiss National Bank (SNB), among others, to increase their key interest rates. This sharp monetary tightening by the various central banks has helped to combat inflation. Inflation numbers have recently fallen significantly, and central banks are approaching the peak in the rate hiking cycle. The regulations also have consequences: Demand for loans has dropped and economic activity has been slowed down overall.

The intervention of the central banks has slowed economic growth and has raised questions about the probability of a recession. With rate hikes expected to come to an end in May for the Federal Reserve and in the middle of the year for the ECB, the US and the euro zone should narrowly avoid recession. In Switzerland, Credit Suisse sees a moderate risk of two consecutive quarters with decreasing gross domestic product (GDP). At least as long as private consumption remains resilient, which is expected. Nevertheless, a slowdown seems unavoidable in light of monetary policy tightening, geopolitical uncertainty, and a weak global environment.

2022 marks the strongest fixed-income correction in a century

In 2022, both equities and bonds performed poorly: The rising inflation and aggressive interest rate increases by the central banks led to losses for fixed-income bonds, while weaker growth put a damper on the equity markets. Such a strong positive correlation between equities and bonds within a calendar year is rather unusual and was last seen in 1969.

2023 also promises to be an unusual year, albeit in different respects. The strong start of the financial markets at the beginning of the year was followed by the collapse of several US banks in mid-March 2023 as well as by the merger of Credit Suisse with UBS. Although markets have recovered since the low point in March, the yield curves are likely to stay inverted for some time, with moderate growth and high inflation readings in the future. Such an environment leads to uncertainty and volatility, which is also reflected in the interest rate volatility index of Credit Suisse. Said index currently shows an unusually high volatility outside of a recession.

What do inflation periods mean for investors?

Continued high volatility on the markets is expected. This is likely to create continued headwinds for growth and, therefore, risky assets such as equities. In this environment, Credit Suisse recommends acting in a considered manner without losing sight of long-term goals. Especially after the upheaval of March 2023, Credit Suisse recommends the following:

• Stay calm
• Carefully analyze portfolio allocation
• Look for investment opportunities with lower risk characteristics

In contrast to equities, bonds have lower volatility and a significantly better risk/reward ratio. For this reason, bond markets have become much more attractive compared to other investment categories, especially equities. Fixed-income bonds have advantages compared to riskier investment categories as well as in absolute terms – provided they generate higher yields in the future. This advantage is linked to past interest rate movements.

Credit Suisse expects that interest rates will remain at a higher level, marking the end of the low interest rate environment that has prevailed since the 2008/2009 financial crisis. Due to this trend reversal, there should be an increase in expected returns from bond investments. Given this situation, bonds can once again play a more important role in investors’ portfolios with renewed diversification benefits. Therefore, bolstering fixed income allocations in portfolios is a good idea.