Commentary: Inflation and growth outcomes will determine pace of central bank tightening

Performance review

Despite firming global inflation, bond prices recovered some of October’s weakness in November and December. Bond yields moved lower, aided by the uncertainty surrounding the new Omicron COVID variant. The portfolio’s underperformance was concentrated in the month of October where although we were short duration versus benchmark, we were positioned for Australian bonds to outperform global markets, and for longer-term, rather than shorter-term, inflation expectations to move higher.

We have made several portfolio changes and adjustments over the last quarter. Increasing Australian duration to take advantage of the higher yields following the October sell-off and to protect from a deterioration in the growth outlook surrounding Omicron. Maintaining yield curve flattening exposure in the US and Australia but taking some profit on very short-dated maturities, reducing exposure to Australian inflation linked securities, and reducing risk in emerging market sovereign debt and Australian credit.

COVID continues to dominate

As we close out 2021, COVID continues to be top of mind for the second year running with Omicron cases rising significantly. Omicron as a milder variant is a compelling narrative that has helped to stabilise markets into year end. It is hard to separate Omicron’s virulence vs other variants given the widespread levels of vaccine and better treatments. Nevertheless, the latest wave is resulting in less hospitalisations relative to previous waves and we see this as one of the key metrics of measuring lockdown risk, suggesting that the global economic recovery is unlikely to be derailed. If there is one thing that we have learned this year, it is that the global economy has proven to be resilient in the face of pandemic-related challenges.

The past year has offered a break from 'the new normal' features of the US economy that dominated the previous decade, as unprecedented policy stimulus coupled with severe disruptions to supply chains and labour supply triggered an inflation spike. How inflation, the labour market, and monetary policy evolve in 2022 will determine whether we return to 'the new normal' or pivot towards higher inflation and interest rates.

Inflation likely to persist

Looking forward, the key risks to markets continue to be around inflation and growth. Growth appears to have peaked from elevated levels and whilst slowing, stills appears to be above trend. Inflation is expected to peak in the first half of 2022. Against this backdrop there is also concern that the fiscal pulse will be weaker going forward and that monetary policy settings remain extremely accommodative and will need to be adjusted. Markets are pricing in official rate increases, hence the recent volatility in sovereign bond yields, however the transition to more appropriate monetary policy setting has only just begun. The reaction function for the central banks around the actual timing and pace of the adjustment remains tied to the data which as we know can surprise and lead to spikes in volatility.

Although we are optimistic about the outlook for the global economy, we see considerable risks to orchestrating a soft landing where the biggest downside risk to growth is that the central banks tighten policy too aggressively to tame inflation. Current market and macro conditions should encourage central banks to press ahead with a tightening cycle. The rapid pull forward of expectation for a global tightening cycle starting early in 2022 has been the main driver of bond market volatility in the December quarter. Upside inflation risks will require central banks to stay nimble and possibly act earlier and more aggressively. This should create further upside to yields as we move through the first half of 2022. The risk of more hawkish central banks keeps us positioned for flatter yield curves to reflect the move higher in interest rate expectations. We did take some profit on these positions, adding back some duration in both Australia and the US as markets are now priced for a 1% cash rate over 2022 in both countries. This has reduced our short duration position in the US, where we now hold a modest short in the front to mid-part of the yield curve.

The local bond market

In Australia, we believe the yield curve looks unusual compared to elsewhere, with more official interest rate increases but lower inflation factored into current yields. The RBA is adamant that it won’t be lifting official rates until core inflation, driven by stronger wages growth, picks up. We think it will and the RBA will be forced into action earlier than it expects, but still slower than the US Fed and other developed markets. Our preference in Australia has been to own inflation-linked bonds, be positioned for a pull-forward of rate increase expectations and preferring longer-dated government and semi-government bonds that offer value. We have recently moderated this view by trimming some inflation linked exposure as we look to position for a move higher in real yields as rate hike expectations now look fully priced in Australia.

While short end bond yields are likely to come under more upward pressure with central banks now clearly in play, long end yields are still relatively low. Markets are pricing much lower terminal official rates in this cycle with the view that central banks will not be able to lift interest rates too high without slowing growth or derailing risky assets. Other arguments against a higher terminal rate takes us back to 2018 where the US Fed increased rates too much (up to 2.50%), then realised its policy mistake and lowered the cash rate to 1.50% in 2019. Another argument against higher terminal rates is that the economy cannot handle higher rates, given the high level of debt. We think the topic of higher terminal official yields is likely to gain importance in 2022, as the focus shifts more squarely to the rate hike cycle. The market’s conclusions about the terminal rate will be important to decide the direction and level of yields in 2022.

Credit still vulnerable

With faster policy tightening a key risk for 2022 alongside the withdrawal of liquidity by central banks, credit remains vulnerable to further weakness. Reduction of central bank balance sheets has now started and historically, credit spreads start to widen 6-12 months from when tapering begins, with spreads peaking at 11-16 months. The extent of credit widening will depend on whether we pivot towards higher inflation and interest rates or we return to the ‘new normal’. Credit spreads in general, are expensive to extremely expensive for high yield markets but investment grade markets have moved to more neutral levels. This pricing for perfection indicates risks remain skewed to the downside, particularly for high yield markets.  Asian high yield credit markets remain the anomaly with spreads at very attractive valuations. Our expectation is credit spreads are likely to drift wider in the next 6 months as the impact of tapering and balance sheet reduction materialises.  After this point, we expect spreads will remain somewhat range bound with a disappointment in corporate earnings being a risk factor.

Overall, we remain constructively positioned across our credit exposure, particularly in Australia where the market is shorter in duration and higher credit quality than global credit markets. However, we have reduced our position by adding some hedges in Australian credit via derivatives and maintain our hedges in US high yield, leaning against stretched valuations and further weakness as we move through this mid-cycle slowdown. Our global exposures include allocations to US securitised assets, Asian corporates and a modest exposure to emerging market sovereign debt.

Expect more volatility in 2022

As we embark on 2022, the outlook for bond markets remains challenged given the uncertainty over the persistence of inflation, the impact on growth and the central bank response. We are expecting more volatility in rates markets where extreme moves do create opportunity. As we work through this next phase of expansion, the interaction between interest rates and riskier assets needs to be monitored carefully. We are more cautious on risky assets given the upcoming stimulus withdrawal. We are actively managing the portfolio to provide diversification and a low-risk source of income to broader portfolios and expect these characteristics to remain even as the environment for fixed income is under pressure.

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