The beginning of 2022 has proven to be extremely challenging for the global fixed income markets. Investors, consumers, and businesses alike have had to deal with the strongest inflationary pressures in 40 years. These pressures have been made worse by a commodity price shock, geopolitical uncertainty resulting from the conflict in Russia and Ukraine, and tighter global financial conditions as a result of the switch to less accommodative central-bank monetary policies. While the market turmoil of this year has led to negative total returns across most fixed income sectors, it has also created lucrative opportunities for investors with longer-term time horizons.
Fixed Income Market Outlook – Key Insights for 2022
2022 has been a year dominated by volatility for markets. The root of this market volatility is attributed to inflation uncertainty, which has resulted in policy uncertainty. The U.S. Federal Reserve (“Fed”), which was once the leader of “team transitory”, is now shifting its strategy. Heading into the second half of the year, the direction of rate policy will have significant implications for market returns, recession risk, long-run inflation, and the durability of the 60/40 portfolio.
Although the US Federal Reserve’s underlying hawkishness is still present, a turn is beginning to become apparent. For the time being, it is anticipated that the Fed will keep up its front-loaded hiking cycle. The prospects of developed markets edging closer to a recession are becoming more likely as global macroeconomic fundamentals continue to deteriorate. The probability of a hard landing continues to be the base scenario. In order to re-anchor dangerously growing inflation expectations, central banks will end up pushing their respective economies into recession either accidentally or on purpose.
The Fed is continuously arguing for front-loading interest rate increases as it tries to bring inflation under control. On Friday, August 26th, at the Jackson Hole Economic Symposium, the Fed’s Chairman Jerome Powell ended speculation of a Fed lean towards cutting rates to aid the economic recovery in the short to medium term. To ensure stability in price, a restrictive strategy would have to be adopted for an extended period of time. The Fed Chairman confirmed that the department would utilize everything in its inventory to decrease inflation, which has elevated to a level that has not been seen in the past 40 years. Even with four consecutive interest rate increases, which totaled up to 225bps this year, Powell said that they will not stop.
Fed Chairman’s Comments Move Fixed Income Markets
According to Trackinsight’s fund flow data, Europe-listed fixed income ETFs attracted a total of USD$335 million of investor capital between August 22nd to August 26th, which means that this is the sixth consecutive week that has experienced net inflows, and the second week that has experienced average returns that are negative. Powell has been clear with regard to price stability and fighting inflation and was quoted saying that “The Federal Open Market Committee’s (FOMC) overarching focus right now is to bring inflation back down to our 2 percent goal.” He also stated that without price stability, the economy will not be able to achieve a sustained period of strong labor market conditions that benefit all.
Powell’s hawkish statement that restoring price stability will probably require maintaining a restrictive policy stance for some time, even at the expense of slowing economic growth, echoed across the markets with the S&P 500 falling from 4,197.16 to 4,057.99, a 3.32% drop and the largest for several months. On the fixed income side, U.S. Treasuries rose in anticipation of ever-increasing interest rates, and it is pertinent to note that the 2-year US Treasury jumped more than the 10-year Treasuries. Government Bond ETFs also reacted positively to the news attracting USD$350 million of net inflows, while in sharp contrast corporate debt ETFs lost US$195 million over the week across all credit ratings, the largest outflows in the fixed income sector.
From a credit rating perspective, investment grade bond ETFs took the major chunk of inflows, having brought in USD$850 million of investor cash. In comparison to this, their high-yield counterparts registered almost USD$118 million in net outflows for the same period.
Last week’s flow leaders included the iShares Core € Govt Bond UCITS ETF (IEGA). The fund was able to lure USD$85 million of net inflows, meanwhile holding funds of USD $3.8 billion of assets under management. The fund follows the performance of an index that is composed of Eurozone investment-grade government bonds.
Additionally, the Amundi Index Euro Corporate SRI 0-3 Y UCITS ETF (ECRP3) was attractive to European investors for the fourth consecutive week. It attracted USD$65 million of investor capital as compared to the previous week’s USD$0.5 million. ECRP3 allows its investors to have access and view of a range of investment-grade, euro-denominated bonds. However, it excludes issuers that are involved in alcohol, tobacco, gambling, military weapons, nuclear power, adult entertainment, civilian firearms, genetically modified organisms, thermal coal, and oil sands.
On the other hand, bond ETFs saw large outflows including the iShares Core € Corp Bond UCITS ETF (IEAC) and SPDR Bloomberg Emerging Markets Local Bond UCITS ETF (EMDD), losing USD$300 million and USD$113 million, respectively.
Fixed Income Perspectives
Goldman Sachs
According to a report by Goldman Sachs, geopolitical risks are at an all-time high right now, growth is normalizing and a sustained inflation impulse due to commodity and supply chain disruptions is leading central banks to press ahead with policy unwind as was anticipated entering 2022. Disruptions to commodity supply will likely be the major factor in the economic and financial market implications of the Russia-Ukraine war. However, it is unlikely that the economic costs will be evenly distributed. In addition to this, the current shock involves all commodities including energy, food, and metals, and will likely affect Europe more than the US.
The report also states that replacing the world’s second-largest commodity producer will require a long duration and renewed fiscal spending could prolong inflation pressures. Navigating the investing landscape during a war in Europe and an ongoing pandemic highlights the importance of both humility and investment discipline.
In light of this, Samuel Finkelstein, Chief Investment Officer Fixed Income and Liquidity Solutions at Goldman Sachs has stated that due to the hawkish reassessment of policies of the central bank and the impact of the ongoing war in Europe on the market, volatility in the market could be seen over the coming time period. Due to this, few segments of the fixed income market seem lucrative as risk premiums accumulate. This includes investment grade corporate credit, where strong balance sheets act as an anchor, even though the inflation is elevated and there is geopolitical uncertainty in the world.
On the other hand, Whitney Watson, Global Head of Fixed Income Portfolio Management, Construction & Risk, Goldman Sachs Asset Management has also stated that the new reality of the geopolitical situation and the energy market that has been formed by the Ukraine conflict really signifies the importance of energy security and transition. Watson also stated that the ongoing war and its resultant energy inflation has highlighted the importance of an ESG domain in order to manage downside investment risks and form a balanced approach to fixed income asset allocation.
BlackRock
According to a report by BlackRock, the market’s response to the inflationary currents is similar to previous such scenarios. This signifies that, by the end of 2022, there is an expectation of a Fed tightening at a quicker speed, around a neutral rate of 3.5%. It seems the Fed department is quite sure that the quicker pace will be able to control inflation. It is also being suggested that the market will experience a relatively soft-landing with the increase causing rates that are slightly too tight and then the Fed subtly easing back to neutral.
The report has also indicated that the Fed, along with other central banks of the developed markets are now realizing that they would need to get more stringent in order to control the soaring inflation. The report also states that across the globe, a long list of central banks of the developed market have now started aligning themselves to rein in the rising inflation. This has created a cascade of hawkish monetary policy. All around the world, the rates have continued to move higher with the European Central Bank’s (“ECB”) and the rates have been increased, for more than a decade. The ECB has to experience a more complex policy environment as compared to the US, as it has to fight inflation through hiking rates and at the same time limit policy fragmentation across the Eurozone.
In the context of the present tightening phase, the ECB’s move towards developing a distinct “anti-fragmentation” tool highlights the difficulties of normalizing policy to fight inflation without exacerbating the unintended side effect of more fragmentation. Intra-European bond spreads noticeably widen as a first effect of tightening. They are currently halfway between the extremes of the 2010–2012 Eurozone Sovereign Debt Crisis and the widest COVID levels of 2020. Following the announcement, spreads have tightened as a result of the ECB’s decision to begin building an explicit anti-fragmentation instrument in response to these market movements.
Vulnerability of the “Diversified” 60/40 Portfolio
Typically, when growth assets, like stocks, sell off due to an economic downturn, safer assets, like bonds, appreciate as investors seek stability. While stocks tend to suffer in a recession due to the decline in economic growth, bonds can rally because the US Federal Reserve typically cuts interest rates to support the economy. Bond yields decrease while bond prices increase when interest rates are reduced. This acts as a portfolio’s shock absorber, reducing the impact of dropping stock prices on overall returns. For many years, the basis of “diversified” 60/40 portfolios has been this stock-bond balancing act. A rising level of inflation, however, limits the Fed’s ability to support the equities markets by cutting rates, thereby rendering the “Fed put” ineffective.
Due to this perplexing combination, standard 60/40 portfolio investors are exposed. Bond prices have only increased while stocks have declined three times since 1929. Except for the years 1931, when Britain abandoned the gold standard (which resulted in falling equities but rising interest rates to protect the currency), and 1941, when the US entered World War II (leading to rising inflation and falling stocks), 1969 stood as the exception that proved the rule for reliable stock-bond diversification.
The reasons for losses in that period are similar to today, with rapidly rising inflation unleashing a Fed tightening cycle that eventually resulted in recession. That time showed how bonds may be a terrific stock diversifier, unless stocks are declining owing to inflationary worries.
Fidelity International
According to a report by Fidelity International on fixed income perspective, at the September 15th FOMC meeting, a 75bps rate hike is likely and the terminal rate might have risen to 4% from 3.25-3.5%, with any pivot, now pushed out later in the first half of 2023.
Given the extent of the debt in the system and the fact that quantitative tightening is still escalating, draining US$95 billion a month from its $9 trillion balance sheet, further tightening financial conditions, the monetary tightening by the Fed to re-anchor inflation expectations runs the risk of sending its economy into recession. The result will probably be looser policy to boost economic growth the following year. Given the global demand for US dollar debt refinancing, it is important to monitor dollar liquidity conditions under US quantitative tightening. This isn’t a prominent risk now and the Fed has tools to fight this.
According to the report, in core European bonds, we are also long duration. The European economy is in a difficult situation and is likely to enter recession soon, whatever the ECB does. Adding monetary tightening to the mix could accelerate the downturn, and authorities may reverse course sooner than the market might think. The report suggests that investors should prioritize protection in this recessionary environment. The report also highlights that Fidelity favors investment-grade bonds, where valuations remain relatively attractive, especially in Europe. After Powell’s remarks, investment grade yields scarcely changed, which may be an indication that hawkish sentiment has peaked. High-yield spreads, in contrast, have not yet fully accounted for the danger of a harsh landing. One-year defaults in US high yield markets, for instance, predict a default rate of just 2.3%, which is consistent with a fairly shallow recession.
According to the investment firm, now is the moment to play it safe and invest in investment-grade markets rather than high yields.
Market Conditions Remain Choppy
Looking ahead over the balance of 2022 and into 2023, it seems there should be ample relative value opportunities to continue adding credit risk at wider spreads and to seek to take advantage of fixed income market dislocations. However, it’s also crucial for investors to manage their cash with flexibility and aplomb. To be able to take advantage of market opportunities as they present themselves includes maintaining a sizeable portfolio allocation to cash and liquid developed-market government bonds.
The direction of inflation is the primary concern or issue that is driving markets today. As long as it remains unclear if central banks are successful in reeling in inflation, there will be an environment where stock markets and bonds markets have the potential to move down together. During this moment, it will be unclear if bonds’ ability to diversify investments will be reliable. Although it might only last a few quarters, this time frame could potentially be longer.
Will the Fed stop hiking rates if it looks like we are winning the war against inflation later this year to prevent further damage to employment and growth? Will they unintentionally quit too soon or simply accept greater inflation? A lengthier period of inflation uncertainty could result from this scenario, and it is this uncertainty that will keep markets volatile. In the interim, it appears that central banks will require a considerably larger boat to combat inflation.
Although these are difficult times, experts have cautioned against being overly defensive, which could limit return potential in recovery. Diversifying exposure to different styles and regions is crucial in this regard. Investors with a strong inclination for growth companies may want to switch to value equity portfolios, which should do well in an environment of inflation. For example, China, which may be ready for a comeback given its relaxing monetary policy and fiscal stimulus, is one of the emerging markets with the lowest allocation of investors despite favorable values.
Expert opinions in these times have been well-reported by Reuters. Matthew Nest, State Street Global Advisors’ global head of active fixed income predicts that at some point, the anxieties will transfer from inflation to growth. Additionally, he believes that bond yields have risen to such an extent that they are quite attractive.
The question right now, according to Mike Riddell, a senior fixed income portfolio manager at Allianz Global Investors in London, is not whether we will enter a recession but rather how deep it will be and whether there will be any kind of financial crisis or significant global liquidity shock.
Riddell predicts that the renewed hawkishness of central banks will result in an even worse global economy by the middle of next year since monetary policy sometimes works with a lag. He stated we are of the view that markets are still substantially underestimating the hit that is coming to global economic growth.
