High-quality bonds for now, pivot into riskier assets later this year

Fixed income markets began 2023 on much firmer footing than in 2022, a tumultuous year. In spite of the rally in rates during March, we believe high-quality bonds still offer the best opportunities that they have in many years (Figure 1). It is not often that bond investors get excited, but we believe that there is good reason to focus on the asset class now as valuations are the most attractive they have been in more than a decade.

Figure 1: Yields: Bonds, equities and cash

_{Source: Bloomberg as of March 31, 2023. Shown for illustrative purposes only and should not be interpreted as investment guidance.}

Despite our exuberance, we submit one caveat: while we believe higher quality fixed income offers compelling value, because we expect Treasury yields to move lower, we still identify vulnerability in riskier segments of the market, such as longer dated corporates and high yield, where we expect spreads to widen as growth slows.

Headwinds become tailwinds

We witnessed encouraging returns in fixed income at the start of the year and we expect this trend to persist as the year progresses. Last year’s headwinds are likely to become tailwinds this year as inflation has peaked, growth is slowing and the Federal Reserve (Fed) pauses or even reverses its tightening course. These regime shifts combined with the highest yields in more than a decade create a much more favorable backdrop for fixed income returns. While we have some way to go to recoup last year’s losses, we experienced a promising start to 2023 (Figure 2).

Figure 2: 2022 and 2023 YTD fixed income sector returns

_{Source: Bloomberg as of March 31, 2023. Current performance trends may not continue or lead to favorable investment opportunities.}

The macroeconomic backdrop and the Fed are likely to support bond valuations. While history may not always repeat itself, it often rhymes. Looking at previous hiking cycles, we see that bond yields have historically peaked 13 months after the first hike, which was March 2022 in this hiking cycle, and around the Fed’s penultimate hike (Figure 3). This pattern justifies our view that bond yields have already crested and they will continue to move lower this year as growth falters and the hiking cycle ends.

Figure 3: 10-year Treasury yield vs. Fed Funds target rate (in %)

_{Source: Bloomberg, Schroders as of March 31, 2023. Economic indicators and related historical trends may not be accurate measures of market activity and should not be relied upon to predict future results.}

Soft landing, no landing or recession?

Remarkable volatility has already colored this year in bold hues. Economic optimism and soft landing narratives were trumpeted throughout the markets at the beginning of the year. The sweet music became a pained lament as panic ensued in the wake of Silicon Valley Bank’s (SVB) collapse and harrowing deposit outflows from regional banks. As ever, the truth lies somewhere in the middle. However, it is clear that prior to SVB’s demise, growth was already slowing and credit conditions were tightening. The recent volatility will only serve to accelerate both of these trends. The leading indicators we track in the economy have been flashing red in recent months with money supply contracting, yield curves steeply inverting and credit conditions tightening (Figure 4). Thus we anticipate that growth will continue to slow in the coming quarters. Even if the Fed cuts rates this year, the lagged impact of last year’s hikes—the most aggressive in a calendar year on record—will continue to impact the country and the economy as the year progresses.

Figure 4: Leading economic indicators suggest weaker growth ahead

_{Source: Bloomberg, Schroders as of March 31, 2023. Economic indicators and related historical trends may not be accurate measures of market activity and should not be relied upon to predict future results.}

Whether it results in a recession is less of an issue but our bias is that it probably does and the recent Fed minutes suggest policymakers now agree with that view. What is important for markets and risk assets is the rate of change in growth, which continues to slow. With valuations in both equities and credit extrapolating a much more benign outcome, we believe we are likely to have better opportunities to invest in riskier sectors later this year. As we can see in the simple regression charts in Figure 5, both investment grade and high-yield spreads are currently discounting a very benign economic outlook, which is inconsistent with our expectations. The green dot in the chart is where the spread and GDP levels were as of March 31, 2023 and the dotted line shows the regression analysis results based on historical data. You can see that the green dot is considerably lower than the dotted line when measured against the Y-axis, indicating that current spread levels are tighter than would be expected for this current level of growth.

Figure 5: Current corporate spreads imply much stronger growth rates

_{Source: Bloomberg, Schroders. March 31, 2023. Economic indicators and related historical trends may not be accurate measures of market activity and should not be relied upon to predict future results.}

When the Fed hikes, something invariably breaks

One thing is certain, when interest rates rise, animal spirits cool down, market valuations decline and overall economic activity slows. Given that it typically takes a year or more for policy hikes to impact the economy, we will be dealing with the fallout from 500 bps of rate increases over the last year for some time.

The lags between policy changes and economic effects are uncertain, but higher interest rates expose recklessness and speculation, and the banking volatility is no different from the discord in cryptocurrency or growth stocks, or the chaos we saw in UK pension plans and Gilt markets last year. Panics and unintended consequences have defined every hiking cycle in recent memory (Figure 6) and we expect more pandemonium to emerge as the year progresses.

Figure 6: Past crises during rate hiking cycles

_{Source: Bloomberg as of March 31, 2023. Historical market activity should not be relied upon to predict future results.}

We emphasize that the unintended consequence of tighter monetary policy in this cycle has been severe upheaval in the financial sector. We expect financial institutions to hoard their liquidity and extend fewer loans, which will likely adversely impact prospects of economic growth. More broadly, in our view, this is another symptom of tightening liquidity and its impact on hidden pockets of leverage/risks that have accumulated over many years in what was a low-yield/reach-for-risk world.

A new banking crisis?

The turbulence we have experienced in the banking sector over the last month raises legitimate questions about whether we are entering another banking crisis akin to the Global Financial Crisis (GFC). The short answer is no, but the question highlights the lesson we can learn from previous cycles, notably that steeply and rapidly rising interest rates usually spell trouble for economies and markets.

We believe there are some fundamental differences between what happened during the GFC and what is now unfolding. First, capital levels, especially at larger banks, are substantially higher than pre-GFC, providing a significant buffer against losses (Figure 7). Second, underwriting standards and asset quality are much higher, with banks no longer sitting on worthless mortgage debt as the average loan to value today for mortgages is less than 30%, not greater than 50% as it was during the GFC. Finally, the problems at banks, such as SVB, were idiosyncratic and a result of inadequate regulations of banks under $250 billion. Ninety percent of SVB’s deposits were uninsured and a high concentration of its investments were in one sector that was undergoing significant cashflow pressures.

Figure 7: Current banking stress is not a repeat of 2008 due in part to solid capitalization

_{Source: Federal Reserve Economic Data as of December 31, 2022. Economic indicators and related historical trends may not be accurate measures of market activity and should not be relied upon to predict future results.}

The clearest fallout in our view will be the continued contraction of credit in the US economy. Small and medium-sized banks with under $250 billion in assets account for roughly 50% of US commercial and industrial lending, 60% of residential real estate lending, 80% of commercial real estate lending and 45% of consumer lending according to research by Goldman Sachs. These institutions are the ones that have been most affected by the recent stresses that will lead to further tightening of lending conditions.

While more banking stresses are possible, we do not expect this at the larger global systemically important banks (G-SIB) issuers, where our exposures are focused, or banks with more than $250 billion in assets. If anything their resilience may strengthen their footprint and dominance. Within the context of relatively defensive portfolio positioning, we favor exposure to the financial sector and specifically to the largest US and European banks. These banks have diverse and robust deposit loan bases, strong capital and liquidity, good asset quality and are subject to stringent regulation. Despite volatility over the last month, we believe large banks remain an attractive investment opportunity within the broader corporate market.

Where to invest in fixed income?

While we believe the absolute return potential across fixed income remains compelling, not all sectors are created equal. Our preference is tilted towards short-dated, higher quality and more defensive segments of the market, such as Treasuries and agency mortgages because they currently offer compelling valuations, income and liquidity characteristics. With the expectation of a slowing economy creating dislocations and disruptions, we view the liquidity that these assets offer as an additional benefit; liquidity enables investors to efficiently pivot to riskier segments of the market once the impact of tighter monetary policy is priced into securities.

In terms of corporate bonds, credit curves are flat and while the absolute yield available on corporate bonds is interesting from a historical perspective, the proportion of that yield coming from the spread component is low (Figure 8) as compared to the data from before the Fed started to raise rates. As the year continues, we would expect the spread component to widen and Treasury yields to fall, which will likely create opportunities to increase overall exposure to riskier segments of fixed income such as longer corporates or high yield.

Figure 8: Corporate spreads as a percentage of the overall yield has fallen considerably

_{Source: ICE BofA as of March 31, 2023 (left side); Bloomberg as of March 31, 2023. Shown for illustrative purposes only and should not be interpreted as investment guidance.}

Fixed income remains compelling but tread carefully and expect continued volatility in riskier assets

It’s gratifying that fixed income has started this year with positive absolute returns given the material drawdowns we experienced last year. We believe fixed income still offers a compelling opportunity given current yield levels both from an absolute perspective but also relative to other assets classes. We expect Treasury yields to fall over the course of 2023 as the economy slows, inflation tracks lower and the Fed completes its hiking cycle.

Our preference remains to focus on the higher quality segments of the market as we believe risk assets including both equities and higher risk credit currently extrapolate a growth environment that is much more benign than what we consider realistic. We see the value in having ample dry powder in portfolios in the form of Treasuries and agency mortgages, which we believe will serve investors well in the coming months. As always, we will be responsive to market movements and we believe in leveraging increased liquidity to trade more tactically at times as dislocations present buying opportunities. With continued volatility, we expect to encounter better opportunities to materially re-risk later this year and redeploy capital into higher risk alternatives, such as longer dated corporates, and high yield at more interesting valuations.