Capital Market Expectations under Inflation and GDP Growth

As a lead portfolio manager at a large investment fund, you are analyzing capital market expectations (CMEs) in light of recent economic trends. Over the past year, inflation has consistently exceeded the central bank's target, leading to speculation about potential interest rate hikes. Concurrently, GDP growth has shown signs of slowing down, raising concerns about economic stability. In this environment, you need to determine the most likely capital market expectations for equity and fixed income returns over the next three years that align with these trends.

Your colleague, an economist, suggests that sustained inflation could lead to tighter monetary policy, potentially lowering equity returns but stabilizing fixed income yields. In contrast, you believe that a slowing GDP combined with higher inflation may cause a divergence in equity performance while adversely impacting the bond market due to rising yields. Considering these viewpoints, you need to make a recommendation on the appropriate investment strategy that reflects the potential outcomes.