Are we there yet? It's looking more likely
PUBLISHED
2022-12-12
Content
by Kellie Wood - Deputy Head of Fixed Income
In 2022 the training wheels came off as enormous fiscal and monetary support ended, then reversed. The losses of 2022 make it tempting to look back – in awe, in frustration, in anger. Don’t. We expect 2023 to look different for the global economy and markets; growth will be lower or negative and inflation will be lower. Both of these changes are supportive for positive returns from fixed income. Cheaper starting valuations, a function of this year’s poor performance, are a big part of the story.
Our key cyclical views are:
- A deeper global slowdown should arrive early next year. Slower growth is a function of tighter monetary policy. The last 12 months have seen the broadest tightening of global central bank policy since at least 1980. The tightening was so aggressive because inflation kept beating expectations. Going forward this changes. We expect underlying inflation to moderate across the developed world, allowing the global tightening cycle to pause, then reverse.
- For markets, this presents a very different backdrop. 2022 was marked by resilient growth, high inflation, and higher cash rates. 2023 should see weaker growth, disinflation and rate hikes ending (or potentially reversing) all with very different starting valuations. It seems reasonable to think we’ll see different outcomes.
- Of course, for central bank policies and bond market outcomes, the path of inflation and associated expectations will exert the most influence on interest rates
- Even as inflation trends lower in 2023, doubts will remain about the stickiness of inflation, the structural labour market tightness and lower rates sensitivity this cycle. These doubts will likely mean a consolidation phase in bond markets and prevent yields from falling too much initially, even as inflation cools and central banks signal rate cuts.
- The ‘pivot’ in monetary policy depends a lot more on labour markets adjusting, even though the rise in rates in 2022 was mostly driven by the inflation readings. Getting to higher levels of unemployment may not be as straightforward in the current cycle. The current macro-economic environment highlights the risk that labour markets may not weaken sufficiently until we see a sustained decline in growth.
- Soft landings following meaningful central bank policy tightening are rare.
The tension between ‘slower growth is bad’ and the ‘end of hiking is good’ often comes down to how deep the slowdown is. As we wait for this sequencing to play out, we are embracing income. This is an exceptional environment for generating high single digit returns from high quality assets, an opportunity that hasn’t presented itself in a long time.
Several factors align the ‘income’ opportunity. Real and nominal yields have risen sharply, and credit spreads have widened. The cyclical environment is also very supportive for fixed income as we enter a period of less growth and moderating inflationary pressure.
Positioning
With the prospect of easier central bank policies and a moderation in inflation, we are starting to embrace fixed income duration – particularly high-quality sectors with less exposure to growth risks. In addition, we are preparing for steeper yield curves where we expect a sharp downward adjustment in the expected path of policy rates. This will take bond yields lower and generate some very attractive returns for investors.
Slowing growth and the line of sight to the end of the global rate hiking cycle means we are overweighting high-quality bonds. High-quality bonds should outperform more consistently when central banks stop hiking rates. In November, we continued increasing our exposure to investment grade assets via Australian corporate and semi government bonds.
Uncertainty around how far growth falls in 2023 suggests that more patience is warranted in risky assets such as US high-yield. The credit cycle is deteriorating quickly. Credit supply is tightening and should lead demand lower. Defaults will move higher following the lead of surging recession risks, and high-yield spreads are exposed in this fundamental backdrop. We remain cautious on high-yield holding a short position until recession risks are increasingly priced.
With fixed income now standing out as likely offering good absolute and relative value, we assess that the asset class is now well placed to offer good diversification and low-risk income. We are optimistic that better fixed income returns are ahead, and that fixed income will retain strong strategic value to portfolios. We are now more constructive in portfolios, taking advantage of the exceptional value in government bonds and high-quality investment grade – building long positions vs benchmark across both asset classes.