20th June 2022 – Against a backdrop of war, inflation and rate hikes, our fixed income experts comment on 2022 so far and share their outlook for the year ahead.
Global investment grade credit team outlook by Andy Byfield, Senior Client Portfolio Manager
How much longer will the bond sell-off last?
Some of the challenges for fixed income markets this year are caused by global central bank responses to a high inflation, low growth environment. This has resulted in weakness for equity and bond indices, while heightening the risk of stagflation.
Meanwhile, US dollar strength and the uncertainty created by Russia’s invasion of Ukraine have exacerbated ongoing stagflation risks. This environment has also led to increased volatility and a sharp tightening of liquidity conditions.
With the Federal Reserve only just beginning to tighten monetary policy, inflation expectations rising and bond fund outflows continuing, there’s evidence to suggest this bond bear cycle could deepen further.
This is particularly true given concerns around:
- A tight labour market in the US keeping pressure on wage growth.
- China’s zero covid policy continuing to disrupt supply chains.
- Higher energy and food prices because of the Russia-Ukraine conflict.
These are three key inflation factors that we are watching closely as we try to establish when bond markets will turn. We believe that this stagflation backdrop (high inflation and moderate growth) will lead to a stagnation environment (low inflation and low growth) rather than a reflation scenario (high inflation and high growth).
We believe the current stagflation scenario means the high inflation will result in slowing growth with tightening financial conditions. This suggests we are entering the late stages of the economic cycle, which typically sees government and investment grade corporate bonds outperforming riskier asset classes such as equities.
We feel a recession is unlikely, but it could materialise if central banks overtighten or tighten monetary policy too quickly.
Could there be light at the end of the tunnel?
It has been a difficult period for bond holders, and uncertainty remains elevated. However, we are now more optimistic about the medium to longer term value in the asset class given the significant yield improvement across investment grade credit markets globally.
The index2 yield of the global investment grade credit market is now close to 4% (US dollar terms), which is higher than the peak yield of the covid shock in March 20201. The last time we saw such high levels of yield was during the 2011 European sovereign debt crisis, when fragmentation concerns coincided with the first ever credit rating downgrade in the US. As such, we believe yield levels are very attractive, particularly from an income perspective.
Fixed Interest team outlook by Stuart Edwards, Fund Manager
After a difficult start to the year, we are shifting towards a world where we are once again being paid for taking risk in fixed income.
It is a market that has, for much of the past decade, been distorted by unconventional central bank policies. Why is it now offering opportunity?
Cautious opening to the year
We commenced the year positioned defensively, both in duration and credit, as we believed inflationary pressure could lead to a significant uptick in yields. This mirrored our 2022 outlook which identified the prospect of a much sharper upward move in yields – one which could easily unsettle credit and equity markets.
So far, 2022 has seen an aggressive repricing of interest rate expectations as central banks have recognised that inflation risks are more than transitory.
The pre-existing supply chain pressures have been exacerbated by the Russian invasion of Ukraine, leading to soaring energy and food prices. In turn, inflation pressures have broadened and expectations for high inflation have fed into forward looking survey data and wages.
Most of the repricing in bond markets has been duration led with, to a lesser degree, some spread widening on top. Yields have adjusted aggressively to the new reality.
The greater interest rate sensitivity of the short end of the curve means there has been a significant flattening. For example, US two-year Treasury yields have increased from 0.73% to 2.62% and 10-year from 1.51% to 2.83% this year2.
While US Treasuries initially received perceived safe-haven flows around the time of the Ukraine crisis, it proved very short-lived. The economic consequences and repercussions for inflation and interest rate policy trumped the safe-haven flows.
This sell-off also marks a recognition that, given the deteriorating trade-off between inflation and growth, the notion that central banks will come riding to the rescue has significantly diminished. The so-called ‘Fed put’ is no more.
Could there be a more attractive risk premium available to investors?
The new reality means an end to quantitative easing for the foreseeable future and the start of quantitative tightening in many jurisdictions. Consequently, private investors may need to absorb more of the net supply in government bonds and credit markets.
The equilibrium ‘clearing level’ for bond yields – absent the influence of central banks – will therefore be higher. This is ultimately a healthy development for fixed income markets once that journey has been completed. It means that returns on offer could be more commensurate with the underlying credit risks, without the distortions we have seen from the unconventional policies of the last decade.
The market is trying to reconcile the twin risks of lingering inflation and downside growth risks that appear to be materialising, partly due to the rise in the cost of living. For now, employment levels are high, and economies are still benefitting from the ‘opening up’ post covid.
The increase in macro uncertainty and market volatility means that there should be more risk premium embedded in all markets, not just fixed income. We are seeing signs of this already.
In bond markets, we expect to see more divergence of returns between those parts of the market that have repriced and those that have not yet done so. However, corporate balance sheets are healthy and in our view, default risk should remain contained in the short term.
Going forward, much of the initial phase of the adjustment in central bank interest rate expectations is likely ‘baked in the cake’, meaning there should be more balance in fixed income markets at these levels. We believe that with yields at more attractive levels, the asset class is offering better opportunities than at the turn of the year.
Investment risks
The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.
Important information
All data is provided as at the dates shown, sourced from Invesco unless otherwise stated.
This document is marketing material and is not intended as a recommendation to invest in any particular asset class, security or strategy. Regulatory requirements that require impartiality of investment/investment strategy recommendations are therefore not applicable nor are any prohibitions to trade before publication. The information provided is for illustrative purposes only, it should not be relied upon as recommendations to buy or sell securities.
Where individuals or the business have expressed opinions, they are based on current market conditions, they may differ from those of other investment professionals, they are subject to change without notice and are not to be construed as investment advice.
Footnotes
- Bloomberg Global Agg – Corps (USD hedged), Bloomberg, 30 April 2022
- Macrobond, as of 19 May 2022
