Inflation at multi-decade highs forced central banks to rapidly raise interest rates within a short period of time, pushing up bond yields1 across the board. That provided little respite to those looking for a diversification from equities as both asset classes suffered at the same time. However, we are now nearing the end of the rate hiking cycle as growth concerns increasingly occupy the minds of policy makers. We believe this can provide an attractive entry point for investments in bonds. We would go so far as to call this a once in a generation opportunity for fixed income investors.
Winning the inflation battle
A combination of loose monetary and fiscal policy to underpin growth at the height of Covid in 2020 and 2021 as well as the sharp rise in energy and commodity prices triggered by Russia’s invasion of Ukraine earlier this year pushed up inflation. The US alone injected about $9.5 trillion into its economy and many other regions around the world acted in a similar manner to combat the fallout from the pandemic.

However, a number of leading indicators show the inflation environment is changing now although we are still some distance away from reaching the 2% level desired by policymakers. US money supply growth is collapsing, and three-month annualised declines of this magnitude have not been seen since the Great Depression.

US CPI has softened after touching a four-decade high of 9.1% in June as commodity, food and oil prices have fallen from their peak seen earlier in 2022. China’s producer prices have declined to the lowest levels in two years, which should provide relief for US CPI as well. It’s no longer a question of whether inflation will slow from here but rather a question of how quickly it will decrease and where will it ultimately settle.
The soft-landing fallacy
The foremost question in investors’ mind right now is whether recession is a certainty, or whether soft landing is still a possibility. Soft landing implies slower growth and lower inflation without inflicting material spikes in unemployment, significant pain on the economy or further weakness in risk assets. Western central banks started raising rates only towards the end of the first quarter of 2022, but the hiking process has certainly been aggressive.

Typically, economies take anywhere between 12 and 24 months to digest a rate hike or cut, depending on how levered the economy is. If history is any guide, an immaculate transition from high inflation to normalised inflation while keeping growth steady is extremely unlikely. Central banks tend to overtighten under these conditions due to the long and variable lags of monetary policy. We are entering 2023 with policy already highly restrictive, with much of the historic tightening still to be digested and further hikes to come across many markets. In our view this will spur a sharp downturn in growth that is being picked up to some extent by the recent Purchasing Managers Index (PMI) data2 and many of our leading indicators are highlighting this will only deteriorate out into 2023.

A natural corollary of recession will be a steep fall in inflation. Analysis shows that over the past 100 years s the US Consumer Price Index (CPI) declined on average 7% during recessions.
Outlook 2023: Recession looming?
Housing holds the key
One indicator we are watching closely is housing as it is a highly leveraged sector. A fall in that market is expected to have a cascading effect on household wealth, already eroded by the fall in almost all asset prices this year.

Housing prices also influence spending patterns, and ultimately impact the health of the overall economy. The rise in mortgage rates has dramatically reduced affordability, particularly in the US. Prices are falling in the UK, Hong Kong, Canada, New Zealand, Australia and Sweden. China’s property market is also going through a difficult time, which naturally has a bearing on global economic growth.

Finally, housing markets are also important for inflation. Shelter is roughly one-third of US CPI. In recent months shelter CPI has been catching up with the parabolic increase in house prices seen in the last years. Looking at more timely indicators such as rents asked in the market, we can already see a meaningful slowdown. In other words, weakness in the housing market will translate to lower shelter inflation going forward.
Jobs and growth
Looking at the US economy, many market participants have been pointing at the resilience of the job market in recent quarters. Looking at leading indicators we are already seeing a number of redundancies or hiring freezes being announced by major US corporates, especially in the technology sector. This will, over time, become clear in key data points such as payroll numbers and initial jobless claims.

Overall, the growth backdrop should prompt central banks to pause and then reverse some of the policy actions of 2022. These could include stopping quantitative tightening (sale of bonds) or starting to cut rates, or a combination of the two. We think the US Federal Reserve is likely to pause rate hikes in the first half of 2023 and move to an easing cycle later in the year. That would be a fertile environment for very strong bond returns.

History shows the Fed pauses between four and six months before easing rates, but a cut could be hastened if unemployment spiked, or other economic indicators deteriorated in a particularly violent manner. Maintaining price stability is a key economic goal of the Fed along with “maximum employment”. Therefore, we would expect Fed action to avert any rapid deterioration in the job market.
Financial accidents, geopolitical risks
Central banks will also be watchful of signs of financial stability risks emerging from hidden or underappreciated leverage that has built up in parts of the market during years of easy monetary policy. In the past, a strong rally in the US dollar, a jump in oil prices or longer dated interest rates hitting certain thresholds have increased the risk of financial accidents. In 2022, we have seen all three occur in concert. Thus, we see the next 12 months as “crunch time” for financial markets and remain alert to early signs of further instability.

The financial markets face other risks too. The Russia-Ukraine conflict is still ongoing, and uncertainty is elevated. We would avoid pinning down specific forecasts for crude oil or natural gas prices as these will essentially depend on unpredictable factors such as the end of the conflict or what kind of winter lies ahead of us. However, it is quite clear that commodities are no longer the main force behind inflation and we might expect some disinflation coming from there in the future as has already been witnessed in certain base metals.
Investment implications
Given the evolving inflation and growth backdrop, we find government bonds in US, Australia and New Zealand very attractive over the medium to long term. In terms of positioning, valuations across parts of the developed market high yield and investment grade corporate bond space are looking compelling. Still, credit selection is important in this environment since default rates are set to climb in the coming years. Therefore, we prefer defensive sectors and secured paper in areas such as telecom and cable for example. We also believe the US dollar is in the process of topping out as we move towards the central bank policy pivot, which, when the time comes, bodes well for emerging market debt, particularly those rich in commodities such as Brazil, and select EM currencies. For the moment our emerging markets exposure remains contained but it certainly remains an area of focus for potential bargains that may emerge.
1 Bond prices and yields are inversely related. Yields rise when prices fall.
2 The PMI is based on a survey of senior executives at companies to gauge economic trends including measures such as new orders and inventories.

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