By Gargi Pal Chaudhuri

In 1971, David Bowie urged us to “Turn and face the strange” – a warning we might do well to embrace today as many nations and consumers grapple with the highest inflation in 40 years, as well as the economic and humanitarian costs of their energy needs. All of this occurs while market volatility continues to spike and the Federal Reserve walks a narrow policy path in subduing persistent inflation without sacrificing economic growth.

Supply chain disruptions that were the root cause of inflation in 2021 are slowly being resolved in spots. Business inventories are back above their pre-COVID trend while manufacturing activity and new orders point to still-strong, but slowing, growth in the U.S.¹ However, the nature of supply chain disruptions is changing due to the geopolitical uncertainty unleashed by the situation in Ukraine. European automakers have cut production this year as industrial parts became harder to source; major global cargo carriers suspended shipments out of fear of regulatory backlash.² And there is potential for a structural change as well: it’s possible that efficiencies built into global supply chains over decades may now be viewed as vulnerabilities, not least because of recent Covid lockdown measures in China, complicating exports. Should reshoring and the localization of supply chains follow, the cost could result in higher prices for the long term.

After spending the last two decades in the benign 1.5-2% range, U.S. core and headline CPI are currently running at levels not seen since the 1980s.³ To combat this, the Fed raised the Fed funds rate by .25% in March, .50% in May, and signaled they could potentially raise rates to ~2.8% by the end of 2023, and announced plans to steadily reduce the size of its near $9 trillion balance sheet. This has led to a sharp increase in yields across the U.S. Treasury curve, led by the very front end of the yield curve. While we believe the longer end of the curve has the potential to move modestly higher in yield, market pricing of Fed hikes in the front end is likely overdone. Though the Fed is talking tough now by signaling sharply hawkish policy shifts and an openness to more rate hikes, in the current environment, we think the Fed may not be able to hike as much as the current market is pricing or as much as the Fed implies in their Statement of Economic Projections without crimping growth.⁴

As rate hiking cycles unfold, they are often met with sharp yield curve flattening and inversions in the 2/10s curve (in which the yield on 2-year Treasuries is higher than that of the 10-year). Markets tend to view this as a harbinger of an economic recession, and growth fears were ignited once an inversion occurred this spring (although the curve has since steepened, which we think should continue). Yet our analysis shows that while yield inversions are often followed by recessions, the timing of the recession after an inversion can be difficult to pinpoint, ranging anywhere from six to 24 months. Even more importantly, equity markets have tended to remain resilient for the first 12 months following an inversion, and in most cases, have delivered positive returns.⁵

Inverted Yield Curve, But Not Necessarily A Recession

U.S. 2-Year, 10-Year yield (U.S. 2Y10Y) inversions & economic recessions

Long Description: Line chart exhibiting yield spread between 2-year and 10-year treasuries and highlighted areas indicating economic recessions that have occurred since 1977. Yield curve inversions, where the spread between 2-year and 10-year treasuries goes below zero, are historically followed by a recession. The chart shows that a yield curve inversion occurred in March 2022.

The upshot of the Fed’s current hiking cycle can be a relatively attractive entry point for fixed income investments in the 1-3-year part of the Treasuries curve, and short duration, highly-rated investment grade bonds as corporate fundamentals remain strong. In equities, despite the underperformance in technology so far this year,⁶ investors may want to consider their current tech exposure to take advantage of this repricing, especially within sub-sectors that exhibit the best pricing power such as semiconductors. In a rising rate environment, allocations to financial sectors such as banks, also tended to outperform the S&P 500 in the 12 months following the beginning of a rate hiking cycle.⁷

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¹ ‘Business inventories’ measured by the U.S. Manufacturing & Trade Inventories Index, sourced from the U.S. Census Bureau as of March 22, 2022. ‘Manufacturing activity’ measured by the ISM U.S. Manufacturing PMI Index, sourced from the Institute for Supply Management as of March 22, 2022. ‘New orders’ measured by the ISM U.S. Manufacturing Report on Business Orders, sourced from the Institute for Supply Management as of March 22, 2022.

² Goldman Sachs Research, “Supply Chains and the War in Ukraine” by Yulia Zhestkova and Daniel Milo. Published March 14, 2022.

³ Source: Blackrock, Bloomberg. As of April 1, 2022.

⁴ Statement of Economic Projections from the Federal Reserve, from March 16, 2022. The Fed – Meeting calendars and information

⁵ Source: Refinitiv Datastream, iShares Investment Strategy. As of April 1, 2022. Equity Markets Performance represented by the S&P 500 index. Yield Curve Inversion analysis references inversion of 2Y10Y yields. Yield Curve Inversion dates in each cycle are 3/24/1998, 2/3/2000, 12/27/2005, 8/22/2019. Past performance does not guarantee future results.

⁶ Source: Refinitiv Datastream, iShares Investment Strategy. As of April 1, 2022. Performance represented by the S&P 500 index GICS sector grouping. Past performance does not guarantee future results.

⁷ Source: Bloomberg, analysis conducted by iShares Investment Strategy. Outperformance measured by analyzing average sector performance after the beginning of rate hiking cycles from 1997 to 2015. Financials represented by S&P 500 Financials Sector GICS Level 1 Index (S5FINL Index). Outperformance compared to S&P 500 Index (SPX Index). Past performance does not guarantee future results.

Carefully consider the Funds’ investment objectives, risk factors, and charges and expenses before investing. This and other information can be found in the Funds’ prospectuses or, if available, the summary prospectuses, which may be obtained by visiting the iShares Fund and BlackRock Fund prospectus pages. Read the prospectus carefully before investing.

Investing involves risk, including possible loss of principal.

Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments.

Technology companies may be subject to severe competition and product obsolescence.

Funds that concentrate investments in specific industries, sectors, markets or asset classes may underperform or be more volatile than other industries, sectors, markets or asset classes and than the general securities market.

Performance of companies in the financials sector may be adversely impacted by many factors, including, among others, government regulations, economic conditions, credit rating downgrades, changes in interest rates, and decreased liquidity in credit markets.

A fund’s environmental, social and governance (“ESG”) investment strategy limits the types and number of investment opportunities available to the fund and, as a result, the fund may underperform other funds that do not have an ESG focus. A fund’s ESG investment strategy may result in the fund investing in securities or industry sectors that underperform the market as a whole or underperform other funds screened for ESG standards. In addition, companies selected by the index provider may not exhibit positive or favorable ESG characteristics.

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This post originally appeared on the iShares Market Insights.

Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.