The Grass Is Greener

HIGHLIGHTS:

• Federal Reserve remarks sparked selling this week as investors brace for rates to potentially reach even higher levels.
• International stock markets have performed markedly better in recent months due to numerous factors, including inflation expectations, but that may be about to change.
• A key inflation gauge for the US and Europe has converged for the first time since the global financial crisis
• Investors are seeking the relative safety of bonds, with high-grade credit funds seeing $70 billion in inflows over the last 10 weeks.

Shares slid after Senate testimony from Fed Chair Jerome Powell signaled the central bank was prepared to take rates higher if inflation continues to run hot. It was yet another reality check for stock markets after starting the year on solid footing. However, not all markets are equal—the grass is definitely looking greener in some foreign markets. To date, US stocks have gained 4.1 percent, while international and emerging market stocks are up 6.4 percent and 3.5 percent, respectively. More starkly, however, over the last six months, that deviation is much higher. US stocks have returned less than a percent, while emerging market stocks gained over 4 percent, and—last but not least—international developed markets rose 15.7 percent. While numerous factors have propelled foreign stocks and dragged on domestic ones, one of the largest has been inflation expectations.

The US economy has been global investors’ focus, particularly as inflation heated up and the Fed took action by aggressively raising rates. Meanwhile, inflation expectations in Europe and other developed regions stayed relatively muted. However, the lack of a more synchronized approach to raising rates may have contributed to a spillover effect. The Fed is currently holding its top-end rate at 4.75 percent—and, according to futures data, it may reach nearly 5.75 percent by the third quarter of this year. At the same time, the European Central Bank’s key rate is currently 3.0 percent, the UK is 4.0 percent, and Japan—a notable outlier due to its own economic woes—has its central bank rate at -0.1 percent. However, that inflation trend, and potentially the outperformance of international stocks, may be reversing. For the first time since the global financial crisis, the five-year forward inflation swap rate—a way to gauge longer-term inflation expectations—for the US and Europe are equal. It seems unlikely, but if consumer prices begin to surge abroad, it would lead to an expected increase in rates as well.

Investors seem to be enjoying the relative safety of bonds as stock markets ebb and flow in reaction to what used to be fairly mundane data releases. As stocks take a beating and even shorter-term bonds provide notable yields, flows to those areas of the market have increased. According to EPFR Global data, high-grade credit funds have seen 10 consecutive weeks of inflows, totaling almost $70 billion as investors attempt to find a safe haven over the near term. In fact, shorter-term bonds are providing yields notably higher than their longer counterparts. For the first time since 1981, the 2-year Treasury yield exceeded the 10-year by a full percentage point. Holding some cash and shorter-term bonds may be beneficial as a defensive play for the time being.

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