Asset Performance in Different Inflation and Interest Rate Regimes

In the face of macroeconomic uncertainty, investors should exercise caution over the positioning of investment portfolios and pay due regard to the evolution of interest rates and inflation. To assist investors in their decision making, we have carried out a detailed analysis on how investment returns have behaved across different macro regimes since the late 1970s and early 1980s. Our analysis considers monetary tightening and easing; interest rate-inflation Markov regimes; and how our findings could inform investor positioning in the current environment.

This whitepaper has been written in collaboration with Anthi Tsouvali, Senior Macro Strategist at State Street Global Markets.

Introduction

As the world was still recovering from the after-effects of the COVID pandemic, Russia invaded Ukraine. Both of these events led to significant disruption in supply chains and sent shockwaves throughout the world economy and have manifested in inflation levels not seen since the 1970s. Against this backdrop, central banks have attempted to contain inflationary pressures by hiking interest rates. The consensus view among economists is that the Fed will continue to raise its benchmark rate at a rapid pace until inflation eases much more, even though economic growth has slowed markedly.

As noted in the 2023 Global Market Outlook, there is the risk of a central bank policy mistake, brought about by monetary tightening that could prove too aggressive. This risk remains even if central banks were correct in initiating or accelerating price hikes in a bid to bring monetary policy in line with employment and price indicators. In view of this, investors should exercise caution over the positioning of their investment portfolios and pay due regard to the evolution of interest rates and inflation.

To assist investors in their decision making, we have carried out a detailed analysis on how investment returns have behaved across different macroeconomic regimes since the late 1970s and early 1980s. While history may not necessarily repeat itself, historical analysis can nevertheless be an instructive guide to the future.

Main Observations

The main observations from our analysis include:

Monetary tightening and easing: 

• Consumer discretionary reacts adversely to rate hikes.
• The impact of interest rates on commodity prices is mixed.
• Contrary to popular belief, utilities is among one of the sectors that has responded least to rate hikes and this is because the relationship between utilities and interest rates is unstable.

Interest rate-inflation Markov regimes. History shows that:

• In the high interest rate level and high Inflation regime, utilities, consumer staples, health care and communication (all defensive sectors) are found among the top outperformers.
• In the low interest rate level and high inflation regime (current regime), commodities and financials have done well. (Note that this regime has been quite unprecedented in a historical context.)

How to position in current environment:

• Energy and health care may present opportunities.