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Overvalued assets could magnify global economic slowdown, BIS warns

11:31, 27 June 2022

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Inflation spelled out on a calculator. Photo: Shutterstock
Central banks are being urged to act quickly to avert stagflation risk. Photo: Shutterstock

The Bank for International Settlements (BIS) has issued a statement saying countries must make decisive rate hike moves to prevent inflation getting out of control and 'becoming something much worse' – that being economic slowdown and possibly stagflation.

Central banks such as the Federal Reserve have already begun such moves. The Fed's rate hike campaign has seen the US dollar (DXY) rise to highs not seen in two decades

In its flagship Annual Economic Report 2022, the BIS says the global economy risks entering a new era of high inflation.

The BIS maintains that a repeat of 1970s stagflation is unlikely due to improved monetary policy and macroprudential frameworks and less reliance on energy, but it warns that the current backdrop of financial vulnerabilities – high debt and overvalued asset prices – could magnify any economic slowdown.

US dollar index (DXY) price chart

“The key for central banks is to act quickly and decisively before inflation becomes entrenched,” said BIS General Manager Agustín Carstens.

“If it does, the costs of bringing it back under control will be higher. The longer-term benefits of preserving stability for households and businesses outweigh any short-term costs.”

What might the likely market impact be of concerted central bank action now?  What are the currency implications?  

Jane Foley, Head of FX Strategy at Rabobank, says the actions of central banks suggest that they are already on board with the thinking that they must make decisive rate hikes to prevent inflation getting out of control.

“The Fed, BoC, RBA, RBNZ, SNB and Norges bank are among those that have already moved in increments of 0.5% or more. The Bank of England has hiked in five consecutive meetings.”

Impact of a strengthening dollar

She adds: “The US dollar has benefitted from a progressively more hawkish Fed from June 2021. Higher US rates and a strong US dollar is not welcome for countries with significant USD denominated debt.

"Concerns related to the outlook for Emerging Markets combined with the relatively resilient stance of the US economy have also helped underpin the USD. It can be argued that for some of the smaller central banks, it may be necessary for them to follow with large moves to prevent their currencies falling. This may help explain the 0.5% Norges Bank move this month and could increase the risk of a 0.5% hike from the Riksbank this week”.

 

US dollar-Norwegian krone (USD/NOK) price chart

In such times of uncertainty it is difficult to predict timescales with regard to impact but Foley suggests there is a risk that market volatility may be enhanced until the Fed’s rate hiking cycle is at an end.

Being risk aware may be the order of the day and as Daniel Dolan, portfolio manager of the iMGP US Core Plus fund, explains  credit risk does still lurk. However, in the bond markets he argues overall credit quality appears strong.

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“If the Fed continues to raise rates, some experts have suggested the economy could slow and the possibility of a recession exists. If that were to occur, economists have suggested the Fed would again be put in a position where it must stimulate the economy.

Attractive yields

He adds: “We believe yields and spreads are as attractive as they have been in three years, barring the pandemic sell-off.

“The key to our credit analysis is an evaluation of free cash flow because, in our opinion, companies who generate it well and allocate it wisely make the strongest case for enduring value.”

Businesses Dolan likes are consumer durable and non-durable, manufacturers, distribution, healthcare, retail, low technology, software and communications.

“The more prosaic the business, the more comfortable we feel in our ability to analyse its prospects.”

“Across the investment grade spectrum, we are now picking up quality names trading between 175-200 basis points over Treasuries. In the high-yield space, we have been able to take advantage of yields approaching 7% - for example, one credit in aircraft parts.

Dolan says he will attempt to take advantage of any decrease in credit quality and spreads in quality names that he already holds, if, as some economists warn, we were to lurch into recession.

Benjamin Graham once said, “The intelligent investor is a realist who sells to optimists and buys from pessimists."

With this in mind, Dolan suggests the present macro headwinds have created plenty of reasons for investors to be fearful. But with a clear and patient mind, he sees the current volatile market as an opportunity to access quality at attractive price discounts.

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