16-May-23 Multi Asset

Long View Q1: Monetary tightening

Transmission of monetary tightening into financial conditions and demand destruction

Christian Scherrmann

Christian Scherrmann

U. S. Economist
Dirk Schlüter

Dirk Schlüter

Co-Head, DWS House of Data
  • Return forecasts for the next decade are relatively unchanged from the start of the year, with a modestly lower fixed income return outlook and modestly more constructive returns for some alternative asset classes.
  • In retrospect, monetary tightening was justified in the US in early-to-mid 2021, which might have set forth a much milder pace of rate hiking.
  • In the shorter term, questions remain around the trajectory of monetary policy contingent on the effects of aggressive monetary tightening on aggregate economic demand. In our view, the peak economic drag was likely in March of 2023.
  • Quantitative tightening likely has a milder effect on economic growth relative to quantitative easing. However, the impact is evident when monitoring the change in longer-term real interest rates.
  • Previous interest rate hiking cycles have proven relatively benign for financial markets, with, on average, constructive credit spreads and equity price behavior. It is not yet clear whether the aggressive nature of this monetary tightening cycle will result in further bank stress.

Summary

 

In this report, we present the DWS long-term capital market assumptions for major asset classes as of the end of March 2023 while exploring the risks to these forecasts.

The first quarter of 2023 introduced the first significant signs of financial stress as a consequence of the Federal Reserve’s (“the Fed”) rate hiking. With the Fed Funds effective rate ending March at 4.83% versus 0.33% bps a year prior, the US economy showed signs of slowing goods demand and modest labor force weakness.

While this incremental demand destruction was intentionally—in order to stem stubborn inflationary pressures, the significant interest rate tightening caused unintended stress across the financial sector. The move higher in both short-term and longer-term interest rates ultimately led to the failure of Silicon Valley Bank (“SVB”) in March and further reflected in price volatility across a number of other regional financial institutions.

While the interest rate hiking cycle appears to be in its final innings, the residual impact on asset-liability management across the banking sector and across the broader economy still poses a risk to financial markets.

In our view, the Fed’s latitude to pivot back to accommodate monetary policy is somewhat limited given persistent price pressures, particularly in the services segments of the economy. The issue of credibility restricts the flexibility of the Fed absent a severe slowdown in economic growth or a significant tightening in financial conditions. The risk of preemptively hiking rates, as we highlighted in the 2023 Long View, is perhaps too great to engage in anticipatory interest rate cutting.

Despite demand weakness, stress in the financial system, and limitations to the Fed’s monetary policy, global markets were resilient in Q1, with global equities returning roughly 7% and corporate credit spreads remaining largely flat. Interest rates, despite significant intra-quarterly volatility, also ended Q1 only modestly lower relative to the beginning of the year.

Our models now forecast an annual return of 6.7% from the MSCI All Country World Index (“ACWI”) over the next decade, versus 6.6% three months prior. At an aggregate level, we estimate the forecasted rate of return on a diversified portfolio of assets at 6.3%, very marginally lower from the level at the end of 2022.

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