Commentary: Fixed income returns to the winner's podium
Commentary: Fixed income returns to the winner's podium
The global economy is in the midst of a marked slowing, and recessionary pressures are increasingly evident. Our key views on the economic cycle are:
- Global growth will languish below trend with several major economies slipping into recession over the next 12-18 months. In tandem, the hot pace of global inflation has prompted central banks to raise rates in the most concentrated tightening cycle in more than 20 years, as the supply shocks remain in play.
- We would not be surprised to see a slowing monthly rate of headline inflation over the coming few months, with commodity prices off their highs, but it is also possible that lingering supply-side and pandemic-related effects keep the rate of change in consumer prices stubbornly high. The speed at which headline inflation will come down is highly uncertain.
- The wider the gap between actual inflation and target inflation, the closer we are to recession. Monetary policy needs to be set in a fashion that causes a rise in the unemployment rate to bring down wages growth and tame inflation. This means central banks need to take policy into restrictive territory. That would almost certainly be recessionary.
- We think it is remarkable (and a dovish surprise) that the US Fed thinks that ‘moderately restrictive’ policy, reached with a shallower pace of hikes, will be enough to quell the highest inflation in 40 years. The increasing attention to growth concerns and the relative rigidity of the policy path amid upside inflation surprises seem to suggest a US Fed that could slow the pace of tightening as we approach a 3% cash rate. However, the near-term path of the CPI does not look very helpful to the Fed’s current dovish stance.
- For now, interest rate markets appear more optimistic about lower inflation risks and the ensuing path for policy, by starting to price the reversal of policy tightening as early as 2023. The path ultimately to lower yields may have a number of twists, turns and consolidation periods.
Medium term themes
- Market and macro moves in the first half of 2022 have set historic records, bringing an abrupt end to the 40-year reign of the ‘great moderation’ in inflation.
- We are not necessarily in a new inflation regime but instead a faster recovery regime. One should think of this new regime not as simply higher inflation, but one of growth and inflation volatility and faster or more volatile economic cycles.
- With an elevated risk of a stagflationary environment, we are likely to see more dispersion around growth and inflation outcomes where investors will want to be compensated with higher risk premia across equities, credit and rates. This will lead to higher rates volatility and wider credit spreads.
- The dramatic repricing of markets this year has greatly improved the outlook for future returns. Our three-year expected return forecasts on Australian bonds is suggesting returns of 4-6% p.a.
The global economic outlook is becoming more supportive of fixed income, setting up for better return potential. Macro fundamentals are suggestive of an inflation peak in the second half of 2022 and the real risk of recession as we enter 2023. The yield landscape has changed, encompassing both higher term and credit risk premium.
- We have moved to increase interest rate exposure within our portfolios as the cycle is now more balanced between upside inflation and downside growth risks.
- As central banks hike interest rates to more neutral levels, we expect to be adding further portfolio duration to position for the peak of the interest rate cycle.
- We have reduced our short positions at the front of yield curves and moving longer duration further out the yield curve where we believe expectations of the slowdown in growth and recession risk will be further priced into markets.
- Credit markets still face challenges ahead – much weaker growth, risks around earnings disappointment and the unsupportive liquidity environment, as central banks reduce their balance sheets. There continues to be widespread anecdotal evidence that earnings will continue to fall as revenue growth is likely to become more challenging to achieve and margins continue to be pressured. Credit markets also face clear downside risk if a US recession does emerge. We have not yet been given the ‘all clear’ signal that would warrant an overweight stance towards more risky credit assets.
- However, spreads have moved significantly wider already, and while we believe riskier credit is still vulnerable, higher quality investment grade corporates offer good value, especially on an all-in-yield basis.
- We remain defensively positioned in credit, but our most recent steps have been to tentatively add some exposure. We will become more constructive as recession risks are increasingly priced into credit markets.
Overall, we are optimistic about the opportunity to reset our fixed income allocations, given the restoring of value across fixed income markets and the better return potential that is ahead of us.
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