Fund Managers Cautious in Q4: AI, Inflation, and Monetary Policy in Focus

As the fourth quarter commences, fund managers are adopting a cautious stance, reducing exposure to risk assets and favoring lower-volatility, defensive investments. This shift is driven by a confluence of concerns, including diverging policies among major central banks, potential risks associated with artificial intelligence and private credit, persistent inflation, and the impact of political intervention on central bank independence.

For multi-asset fund managers at Invesco, this translates to a focus on high-quality government bonds rather than taking on credit risk. They believe that while an economic recession is not necessarily imminent, increasing allocations to defensive assets is a prudent move from a risk management perspective.

Concerns over AI and Private Credit

Concerns over the private credit market are prominent, particularly following the bankruptcies of companies like Tricolor and First Brands, raising fears about potential credit problems spreading to other markets. These concerns led to sell-offs in European bank stocks, although the sector quickly rebounded.

Multi-asset portfolio managers suggest that recent turbulence in the private credit market should give investors pause. They point out that bankruptcies like Tricolor and First Brands caused billions of dollars in headaches for creditors, highlighting the risks of capital misallocation within the shadow banking system.

Additionally, fears of an AI bubble continue to weigh on fund managers' decisions. Analysts note that investment and capital expenditure in AI are providing strong growth support to other weaker areas of the economy, but any loss of confidence in the sector could have a significant impact on financial conditions.

Stagflation Risks Looming

With inflation remaining stubbornly high in several major economies, central bank officials and fund managers are closely watching the United States, particularly in the context of trade tariffs and potential political interference with the Federal Reserve.

Analysts suggest that the lagged effects of tariffs could lead to an unexpected upward spike in US inflation. Markets may also be prone to increased pressure towards the year-end as investors seek to bolster performance.

The former head of the European Central Bank warns that many decisions made by the current US administration have not been fully absorbed by markets, both in terms of inflation and slowing economic growth. He points to the significant fiscal deficit and controversial trade policies as factors that could lead to a form of stagflation.

Central Bank Independence at Risk?

The Federal Reserve's ability to combat inflation relies on its credibility, which has been questioned amid political pressure to intervene in monetary policy. Despite this, the International Monetary Fund believes that inflation expectations remain anchored because investors trust the Federal Reserve's ability to restore price stability.

Experts emphasize that the stability and credibility of central banks are crucial for the proper functioning of markets. Despite the challenges, fund managers see the divergence in policies among global central banks as potential opportunities.

Leveraging Diverging Monetary Policies

Fund managers see the divergence in monetary policies among central banks in developed economies as a key driver of potential volatility and opportunities. While the European Central Bank has already cut interest rates, the future outlook for monetary policy depends on the trajectory of economic growth.

The European Central Bank is expected to keep interest rates steady, with forecasts for European economic growth at 1.2% in 2025. In contrast, the monetary policies of other central banks, such as the Bank of England and the Bank of Japan, may pose potential risks.

The Bank of England faces a delicate balance, as recent interest rate cuts could entrench inflation. A potential rise in Japanese yen yields may incentivize capital repatriation, impacting global credit markets.