Investors must watch out for tail risks from elevated inflation and interest rates, says Melville Douglas

Tail risks from elevated interest and inflation rates and a very uncertain geopolitical backdrop are lurking in the shadows and could put a dampener on hopes for a quick equity market recovery.

This therefore requires a more cautious approach from investors for the time being, says Standard Bank's boutique investment management company, Melville Douglas.

This comes as the global economic recovery is gaining traction, boosting investor appetite for international stocks, even as the geopolitics in the Middle East casts a shadow over investment markets. 

“While we have no reason to doubt the improved economic growth outlook, we must also recognise that several indicators suggest that the global economy appears rather mature or ‘late cycle’,” says Bernard Drotschie, Chief Investment Officer at Melville Douglas. 

While a late cycle is not a sufficient condition for a significant slowdown in economic momentum or indeed the next recession, it is usually associated with a period of more lackluster investment returns. 

“We believe that a lot of the good news linked to a combination of positive earnings momentum, lower interest rates and falling inflation is already reflected in many share prices, with little margin of safety for investors in the event of disappointment,” explains Drotschie. 

He adds that the Israel-Gaza war is a potential risk to the oil market, inflation and interest rates if it escalates into a wider regional conflict.

“As such, caution must be the watchword for investors in the immediate term, with the focus centering on quality businesses until the margin of safety from a valuation perspective becomes more favourable.” 

Investors are counting on central banks to start cutting interest rates from the second half of this year, particularly in advanced economies, given the deceleration in consumer inflation trends. Inflation has been particularly acute for consumers and businesses in advanced economies in the last two years, prompting policymakers to aggressively hike rates, which at the time raised concerns of a sharp economic slowdown or even a technical recession. 

According to Melville Douglas research, the US economy remains “in good shape” relative to Europe and the UK, having absorbed cumulative rate increases of 500 basis points in a space of one-and-half year. 

“While high interest rates have played their part in dampening credit extension and in turn slowing excess demand, fiscal support in the US together with drawdowns on savings and buoyant labour markets have in most part offset the negatives from restrictive monetary policies,” says Drotschie. 

The US Federal funds rate currently stands at 5.25%- 5.50%, the highest level in more than 20 years, having drifted from near zero during the Covid-19 pandemic.  However, with inflation slowly drifting back to the Federal Reserve’s 2% target band, the markets expect the Fed to start cutting rates from the second half of the year.  

Melville Douglas believes the Fed policy pivot has far-reaching implications for other central banks around the world, including emerging markets such as South Africa, to the extent that it shapes inflation profile and interest rates via the rand/dollar exchange channel. 

“In a low rates environment, global equities and fixed-income markets tend to do well. We believe bonds are appropriately priced and together with cash currently provide investors with favourable income yields and diversification while equity markets are trading at elevated levels,” concludes Drotschie.