While the policy cycle appears to be turning and fixed income has started to perform, we could see near-term volatility. But amid a reshaped bond landscape, with higher yields and flatter curves, investors have ways to address market challenges. In our Q1 Bond Compass, we focus on three areas: investment grade credit, emerging market debt and short-maturity strategies.
Determining where we are in the investment cycle is the key challenge for investors. There is sufficient evidence to suggest that peak inflation is now behind us. Peak central bank hawkishness has also probably passed. This is more evident for the Fed than the ECB but, even for the ECB, the pace of hikes has slowed from 75 bps in September and October to 50 bps in December. The third peak, peak rates, has been reached by some emerging market central banks but, for developed market central banks, it remains elusive.
According to market pricing, there is around another 70 bps of tightening to go for the FOMC but this will be heavily dependent on the strength of incoming data. The BoE and ECB are both seen as having well over 100 bps of tightening still to deliver and, given the recent hawkish tone of the ECB, where rates ultimately peak remains less clear.1
The late 2022 rally in bonds suggests that the market believes the risk-reward trade-off looks more symmetrical. There remain risks that terminal rates push higher than the market prices if inflation proves more persistent. A case can also be made, as explained in our Global Market Outlook, that inflation should fall away fairly rapidly later in 2023 on weaker energy prices and base effects. If growth weakens further then there is a chance that central banks start to cut rates. This is the scenario already largely factored in by the market, with the US curve pricing falls in the fed funds rate of close to 40 bps during H2 2023.2
It may take several months before it becomes clear whether the cycle will reverse gear, meaning Q1 could be volatile. In addition, the shape of the Treasury curve, which is heavily inverted out to the long end, complicates the duration call for investors. Taking on more duration in portfolios in the hope that peak rates are close entails sacrificing yield. To a degree, this can be neutralised by focusing on US credit where the term structure of credit spreads acts to neutralise the inversion of the Treasury curve. The yield to worst is around 5-10 bps higher on the all-maturity Bloomberg US Corporate index versus the Bloomberg 0-3 Year US Corporate Index.3
In other words, if the market trades in a range during the coming few months as it interprets the data, then the running yield will be roughly similar whether in the short or all-curve strategy. If the data cools and inflation starts to decline quite quickly, then the additional duration and convexity of the all-curve strategy means that returns from the longer-maturity index will be higher (given the relative duration is 4.8 times higher).
The risk is that the market sells off again. However, losses should be limited by the higher yield on offer and the fact that the 2022 sell-off reduced the duration of most bonds. Given the duration of the Bloomberg US Corporate Index of just over seven years and a yield of 5.45%, the index yield would have to rise by more than 75 bps for the price move in the index to negate the positive yield.
In Europe, opting for a shorter duration profile may be wise given the uncertain economic backdrop. The rapid decline in European energy prices may yet see growth supported. As Figure 1 shows, spikes in gas prices have been associated with wider spreads as growth expectations decline. The recent fall in gas prices could therefore exert downward pressure on credit spreads but will also result in the ECB having to maintain its hawkish stance for longer. This should favour credit versus government bonds. Opting for the 0-3 year part of the IG credit curve involves some give-up of yield (around 25 bps versus the whole curve) but its price sensitivity to moves in rates are a third of the whole curve strategy.
Figure 1: A Rapid Decline in European Energy Prices Should Support Growth
Flows into IG credit were strong in Q4 as investors rebuilt holdings. We expect this trend to continue into Q1 2023 but, with the larger underweight positions now covered, we would expect more of a skew toward ESG strategies. This is consistent with the findings of the State Street Global Advisors Future State of Fixed Income survey. In it, 39% of respondents said integrating ESG considerations is the most important priority to address through their fixed income allocations in the coming 12 months.
The strength of the USD was just one of the several headwinds that undermined EM debt returns for most of 2022. With that trend now having been in reverse since the start of Q4 2022, the coming year could be far better. Indeed, there are several reasons to consider allocations to EM debt for fixed income portfolios.
High yields on offer. The sell-off has created a new landscape for bond returns. The yield to worst on the Bloomberg EM Local Currency Liquid Government Index is more than 6.3%. If the backdrop for bond markets remains volatile then focusing on strategies with a high yield should offer a greater chance that returns remain in positive territory. For those cautious on their duration exposure, there are higher yields to be had in the hard currency market than in local currency.4 This allows investors to shorten duration exposure. Indices such as the ICE BofA 0-5 Year EM USD Government Bond ex-144a Index have a yield to worst of more than 6% for a duration of just over 2.3 years.5
USD expected to weaken further. A succession of risk-off events coupled with a hawkish Fed meant that last year was the year of the USD. However, the DXY (a flow-weighted measure of the USD) does look like it peaked in September 2022. There is no guarantee that weakening will continue unabated in Q1 2023, but the State Street Global Advisors long-term valuation model of the USD versus the basket of currencies that make up the Bloomberg EM Local Currency Liquid Government Index suggests the USD remains 13.2% overvalued (Figure 1). In short, there remains plenty of room for USD depreciation to continue and this typically supports returns from local currency exposures.
Figure 1: Long-Term Value of the USD vs. EM Currencies
Central bank sentiment has turned less hawkish. For most developed markets, the pace of rate hikes has slowed but for EM central banks there has been a more meaningful shift in momentum. Figure 2 shows the diffusion index for 20 EM central banks; the 12-week rolling average of hikes versus cuts has declined from more than 3 in September to 1.4 at year end.6 Trends in PriceStats point to sharper declines in EM inflation than for developed markets and this could open the way for some EM central banks, most notably Brazil, to start easing policy.
Figure 2: EM Central Banks Tightening vs. Those Easing Policy
Investors returning to emerging markets. The invasion of Ukraine sparked an exodus from EM fixed income holdings. While much of that was accounted for by flows in Chinese bonds, investor risk aversion has prevented the rebuilding of meaningful EM positions. The flows data suggests that there was only a fleeting recovery in demand for EM local currency exposures in Q4 and that investors remain underweight. There is still scope to increase holdings.
In summary, EM bond returns in 2023 will be well supported by coupons but performance could also come from an improvement in the economic backdrop for fixed income or from the continued depreciation of the USD. For non-USD-based investors, this does raise the issue that these gains will not translate into performance in their local currency. These investors could consider hedging out their USD risk. For Q4 2022, the Bloomberg EM Local Currency Liquid Government Index put in a strong performance, returning 8.83% in USD terms. However, the EUR appreciated versus the USD by 9.2%, wiping out gains for any EUR-based investor. There is a cost to hedging the EM exposure back to EUR but the EUR-hedged version of the Bloomberg EM Local Currency Index returned 7.72% over the last quarter of 2022.
The success of our first two themes depends on inflation continuing to move to lower levels in both developed and emerging markets, softer growth and a weaker USD. This is consistent with our base case for 2023 (as outlined in the Global Market Outlook) but, given the unpredictable nature and timing of these events, some investors may wish to sit on the sidelines until it becomes clearer that the investment cycle has truly turned.
Waiting for the final rate hike in the cycle to be in place has typically meant missing the early part of the bond rally. And yet, risk-averse investors may be more comfortable with this approach given the recent declines in energy prices could still boost growth and, while headline CPI appears to be on a downtrend, it is less evident that the same can be said for core CPI. According to market pricing, terminal rates for the Fed may not be in place until around mid-year, so Q1 could see some volatility.
The reshaping of the bond landscape means that investors are no longer penalised when opting for short-maturity strategies. Looking at the one-month USD Overnight Index Swap curve, this actually peaks at around the six-month mark, i.e. the one-month rate six months forward is the top of the forward curve. The fact that the market prices rate cuts from the Fed over the course of the second half of 2023 and beyond leads to a negatively sloping curve out to around three years. In order to benefit from high yields and some potential for roll-down (rather than the drag from roll-up), positioning at the very front end of the curve makes sense. The Bloomberg US Treasury Bill: 1-3 Months Index has a yield to worst of 4.40%.7
Figure 1: Peak Performance – Forward Curves Peak Close to the Front End
Bill returns should continue to rise until the fed funds rate peaks, following which there could be opportunities to extend duration. However, the bond market typically anticipates the turn in the Fed cycle so being fully allocated to bills or overweight cash has its performance limitations. Extending a moderate way along the curve can provide some duration exposure. For instance, the Bloomberg US Treasury 1-3 Year Index has a yield to worst of 4.30% for an option-adjusted duration of 1.85 years.8 Given price sensitivity to any further increases in rates is limited, yields would need to increase by close to 250 bps for the price losses suffered to be greater than the annual yield.
While these yields are below current levels of inflation they are elevated in the context of their 10-year history. They are also above dividend yields on most of the key US equity indices.9 So assuming a fairly rangebound performance from both bonds and equities in Q1 implies you would be better off in bonds.
The same is not true in Europe. The equity dividend yield is typically higher than government bond yields at the front end of both the Euro and the UK curves. However, for those considering fixed income as an alternative to equities until the fortunes of the equity markets become clearer, investment grade credit can offer higher yields. This is especially true of the UK, where the yield to worst on the Bloomberg GBP Corporate 0-5 Year Index is more than 5.6%. This is around 200 bps over the UK Bank Rate and is historically wide, potentially signalling fears of recession.
While growth has slowed, a significant recession now looks less likely given the declines in energy prices. In the event that growth did fall into heavily negative territory, this would most likely result in the BoE not raising rates as far as the market currently anticipates (the SONIA curve prices rates rising above 4.5%). Thus credit spreads could widen from current levels but there would be some offset from lower government bond yields.
Figure 2: UK Credit Spreads Remain Historically Quite Wide
1Market pricing of central bank tightening taken from Overnight Index Swap market.
Source: Bloomberg Finance L.P., as of 05 January 2023.
2Source: Bloomberg Finance L.P., as of 5 January 2023.
3Source: Bloomberg Finance L.P., as of 5 January 2023.
4The yield on the hard currency JP Morgan EMBIG Diversified is 8.44% versus 6.79% for the JP Morgan GBI-EM Global Diversified Index as at 4 January 2023. Source: Bloomberg Finance L.P.
5Characteristics for the Bloomberg EM Local Currency Liquid government Index and the ICE BofA 0-5 Year EM USD Government Bond ex-144a Index as at 5 January 2023. Source: Bloomberg Finance L.P. and ICE Indices.
6I.e. the average number of central banks hiking versus cutting rates has halved from more than 3 per week to 1.4 per week.
7 Source: Bloomberg Finance L.P., as at 6 January 2023.
8Source: Bloomberg Finance L.P., as at 6 January 2023
9The dividend yield on the S&P500 is 1.8%, on the DJIA 2.3% and on the NASDAQ 1.0% versus a yield to worst of 4.3% for the Bloomberg US Treasury 1-3 Year Index. In Europe the Euro Stoxx 50 has a dividend yield of 3.6% versus a ytw of 2.7% for the Bloomberg Euro-Aggregate: Treasury 1-3 Year Index and the FTSE All Share has a dividend yield of 4.03% and the 100 index of 4.3% versus a ytw of 3.45% for the Bloomberg UK Gilt 1-5 Index. Source: Bloomberg Finance L.P., as of 6 January 2023.
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