Outlook 2022: Global bonds
Outlook 2022: Global bonds
2021 has proven remarkable and challenging across many different dimensions. We have had a much faster rebound in global activity than almost everybody expected, inflation rates across the world at levels not seen for many years, and the emergence of Covid-19 variants (Delta and Omicron). This has created huge macroeconomic uncertainty.
As we take stock and assess the outlook heading into 2022, what lessons can we learn and how do we position portfolios over the next few quarters?
We think there are three key lessons in 2021, which help guide our outlook as we move into 2022.
Firstly, this economic cycle has evolved rapidly, and far more quickly than the post-financial crisis recovery seen in the early 2010s. This has occurred due to the combination of both monetary and fiscal policy support and the unique nature of the shock. We see potential for economic cycles to remain much faster than we have been used to in recent years.
Secondly, the Covid pandemic has had profound impacts on both global aggregate demand, but crucially on global aggregate supply too. Whereas the post-financial crisis recovery was more clearly marked by demand deficiency, leading to low inflation, this cycle has had implications for the supply side as well. As a result, the trade-offs between growth and inflation have become more nuanced, more complicated, but also more vitally important to understand for economists, investors and central banks.
Thirdly, and most recently, we have learned that there are limits to central banks’ tolerances for inflation, even in the aftermath of strategy reviews designed to help generate overshoots1. Crucially, we have seen they are prepared to remove accommodation once this tolerance is breached. Taken together, we can see that we have moved from a world where “forward guidance” was highly valued by central banks, to a world where “optionality” becomes paramount. We expect this to last throughout 2022, and quite possibly well beyond that.
As we head into 2022, we believe that the peak in global growth that we have seen in the second half of 2021 will become even more apparent. One driver of this slowdown is likely to be the global impact of slowing growth in China. We are beginning to see some signs of policy easing in China. In contrast to the post-financial crisis environment, however, we do not expect a significant stimulus package, but more limited measures to stabilise the economy instead.
To be clear, in our base case scenario we think that in absolute terms growth will remain above-trend for the foreseeable future. In our framework, a peaking in the growth impulse (a falling second derivative) is an important dynamic for asset markets.
In this environment, we do not expect significant increases in yields, especially at intermediate and longer-dated tenors (10 year bonds and longer). In our view these yields are driven by global growth dynamics and structural features such as global debt levels.
Despite continued signs of peaking global growth momentum, developed market central banks are increasingly engaged, as noted in our third lesson. They are particularly engaged with ensuring inflation does not become a persistent threat. This follows persistent upside surprises throughout 2021, and we believe the change in tone will continue as we head into 2022.
This has become most apparent recently with US Federal Reserve (Fed). The December Federal Open Market Committee meeting continued a more hawkish attitude that follows on from other central banks earlier in 2021. In fact, we see emerging market central banks as having been at the vanguard of this global tightening cycle. They have been followed by “higher-beta” G10 economies (those which are smaller and more open) such as New Zealand. The Fed is the latest central bank to grow concerned.
Three investment implications
In our view, this provides clear investment implications. Firstly, a combination of fading global growth momentum, even if still strong in absolute terms, and a more hawkish Fed should see curves continue to flatten, and support the US dollar against a broad basket of currencies.
Counterintuitively, we do not see a hawkish central bank as the biggest danger to intermediate and long-term US Treasury bonds. We would be far more concerned for these assets if the Fed were to remain very dovish in the face of rising inflation risks. However, a more engaged central bank should be negative for shorter maturity US Treasury bonds, supporting our flattening thesis. We have been favourable on yield curve flatteners for much of the second half of 2021, and while this has already played out to some extent, our analysis suggests the move could extend much further.
The second implication is that some central banks, most especially in emerging markets (EMs), are much further through the process of normalisation and therefore closer to the point of finishing. We believe opportunities to be long local currency bonds in some of these EMs could well become compelling during the first quarter of 2022.
This is linked to our view that we are on the cusp of, or potentially already at, the peak in cyclical inflation pressures, which should become clear during the course of 2022. Inflation is likely to remain elevated in absolute terms, as price pressures in goods broaden out to the services sector of the economy. Moreover, we have seen wage growth rise substantially in 2021.
These two factors should keep central banks attentive to the threat of inflation becoming more persistent. But the important development for markets will be if and, more likely, when headline inflation peaks, even if medium term inflation pressures have not. Our analysis shows the coincident correlation between headline inflation and inflation breakeven assets is high. Signs of a peak in headline inflation should also weigh on these assets, with a move toward tighter policy from central banks a further headwind.
Finally, the outlook for riskier assets such as credit is less attractive than it was in 2021. This is also in line with our views that central banks are becoming more attentive to global inflation risks and we are past peak growth for this cycle.
It is too soon to turn outright negative on these assets, certainly without a much sharper slowdown in economic growth than is our base case scenario. We do, however, think the macro environment moving much more clearly into mid-cycle dynamics is less supportive for overall “beta”. Instead, more emphasis will be placed on aspects such as sector rotation within this asset class. Greater volatility caused by central banks and bond markets should seep into riskier asset classes, in our view, providing plenty of opportunity but also demanding patience.
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