A once in a generation opportunity in fixed income?
Ariel Bezalel and Harry Richards look at a turbulent time in bond markets and explain why, rather than doom and gloom, this could be a once in a generation opportunity.
This has been a really tough year for investors. We expect periodic sell-offs in equities, or high yield debt, for example, but usually enjoy the benefits of diversification in “safe haven” assets. A period like this where everything sells off – government bonds, equities, etc – is unusual and particularly painful. Almost nothing has worked this year except commodities.
Markets have been freaking out about higher inflation and increasing pressure on central banks to aggressively tighten policy, slowing growth and risking recession to stamp out inflation. That environment has been painful for most fixed income strategies, including ours.
Coming into 2022, our view was that inflation numbers would start to roll over in the first half of the year. However, Russia’s invasion of Ukraine exacerbated price rises for key commodities, with knock-on effects up the value chain into utility bills, food, and consumer goods of many kinds. That’s delayed the inflation rollover and caused an unexpected hike in yields.
Perhaps counter-intuitively, though, we believe the current spike can only lead to a sharper reversal in yields further down the line.
Recession risks have risen sharply this year and in our view are well over 50% for the global economy. The pressure on the consumer across the globe from higher energy and food prices has driven US consumer confidence to the lowest point since records began in 1978. Real wages have been declining in real terms for over a year. US 30-year mortgage rates have jumped to levels we haven’t seen since 2006.1
At the same time, financial conditions have already tightened materially: the dollar is stronger, money supply has dropped sharply, central banks have been hiking rates across the globe (nearly 200 rate hikes globally since February 2021), fiscal policy is tighter, and the Federal Reserve continues to sound very hawkish.
As we move through the rest of this year and into 2023, we expect the slowdown to accelerate, and inflation to roll over because inflation can’t be sustained without growth. Even in the stagflation of the 1970s, growth slowdowns caused inflation and yields to collapse. That will eventually cause a pivot in central bank policy to slow the rate of tightening, leading to lower yields and a recovery in fixed income assets.
Back in 2020, the first signs that the global economy was reawakening from the pandemic were found in commodity markets, the leading indicators of reflation. Today, prices in agriculture, lumber, copper, among others are starting to roll over.
Energy inflation remains unpredictable given the war in eastern Europe. That said, given oil has already risen by nearly 60% so far this year, the contribution of energy to inflation is likely to moderate. Given the supply chain problems that drove much of higher inflation are naturally working themselves out (see for example queues at US ports), and the economic slowdown, inflation will start to decline, potentially steeply. It’s worth highlighting how the inflation picture can change dramatically in a short space of time. In the middle of 2008, in the build up to the global financial crisis, inflation was running at nearly 6%, yet by July of 2009 deflation had duly arrived.
May’s surprise inflation print drove another selloff in government bonds, with the US 10-Year reaching a level we haven’t seen since 2011. Built into market pricing at the time of writing are expectations of almost 3% of rate hikes by February next year, and a base rate over 4% in 2023.2
Given the impermanence of inflation, the scale of the economic slowdown that is clearly on the horizon today, and with the impact of Fed tapering still to hit markets, we continue to believe that the markets have overreacted. The Fed has been working hard to convey the impression that it will hike aggressively – which in itself helps tighten policy – and have high conviction these hikes won’t be achieved. At these levels, this makes developed market duration a very attractive proposition.
2 Source, Bloomberg, 14/6/22
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