The Fed’s hawkish rhetoric will likely shift over the next year, opening a window for increased opportunities in fixed income.
Fixed income investors will remember 2022 as one of the most trying years, with bond yields rising dramatically year to date translating to some of the worst total returns in decades. Across the board, global yield levels have risen sharply — in both developed and emerging economies. Rising interest rates, market volatility, and widening spreads across sectors have pressured fixed income total returns with an intensity that few experts predicted. Fixed income investors, long accustomed to the diversification, stability, liquidity, income, and total-return attributes of traditional fixed income, have had to reassess their fixed income strategies and embrace a more flexible, tactical, and long-term approach to weather these storms. Investors are eager for a signal that fixed income markets will turn.
Despite these challenges, we expect conditions to shift in fixed income markets over the next 12–18 months. Amid these challenges we do see bright spots and areas of opportunity for investors. One bright spot is that, although price returns have been painful, investors are notably now getting more income from their fixed income than they have in a long time. Current yield levels in most of the major fixed income sectors are either at 10-year highs or at the higher end of these ranges. Record levels of inflation, triggering central bankers’ raising of short-term interest rates, continue to be the main drivers of the bond market’s poor performance. As such, yield momentum remains bearish in the short-term.
Long-term structural indicators continue to point to a low-growth environment anchored by slow labor force growth and weak productivity growth (see Figure 1). Demographics have been trending downward for several decades and are expected to continue to do so in the developed world. Labor force participation is a major factor driving the picture. An expansion in participation could help offset slowing population growth and aging demographics. However, the participation rate remains below pre-pandemic levels, and if we exclude the recent period since Covid, one would have to go back to 1977 to see a participation rate as low as it is today.
The first quarter of 2022 also saw the largest contraction in productivity — down 7.5% quarter-over-quarter1 — that we have seen in 75 years, anchoring longer-term trends in productivity. Debt also continues to pile up, further inhibiting a strong growth environment, and governments, businesses, and consumers face increasing interest costs as a percentage of income. While these trends will continue to anchor real economic activity and therefore real interest rates, cyclical developments in growth and inflation will dominate the short-term outlook.
Cyclically, growth has been slowing since the summer of 2021, and recession risks are rising. The yield curve2 is negative. Forward rate expectations are well above underlying economic fundamentals. And central banks, particularly the US Federal Reserve, have indicated they are getting closer to the end of the hiking cycle.
Year-over-year inflation likely peaked in June of this year and will continue to fall over the course of the next 12–18 months. Some relief from upward inflationary pressures should stem from incremental improvements occurring in supply-side pressures, as well as tightening financial conditions that are already dampening economic activity. In order for inflation to remain sustainably at current levels, we would need to see meaningfully higher moves in long-term inflation expectations, which have remained well anchored. The latest University of Michigan survey found that the median respondent projects inflation to rise 2.9% on average over the next 5–10 years. This represents an increase of only approximately 0.4% in long-term expectations over the past 12 months, during which time year-over-year Consumer Price Inflation (CPI) has doubled from 5.4% to 8.2%. In this context, we believe we are entering the window where investors should consider increasing their allocations to fixed income within portfolios (see Figure 2).
Figure 2: Entering the Window to Consider Increasing Fixed Income Allocations
10-Year Yield Change from 1 Year Before First Rate Hike
We are closely monitoring inflation and the risks of overtightening as the Fed continues its singular focus on fighting inflation. The Fed’s hawkish rhetoric will likely shift over the next year. As we see value building in rates, we prefer duration over spread products and investment grade over high yield. We remain cautious on credit and will continue to be so until the clouds of economic uncertainty begin to dissipate. The market’s volatility which has contributed to credit spreads widening is likely to present opportunities for discerning credit investors. When more clarity appears on the credit landscape, we think investors should consider global markets, including emerging market debt which has been repriced to levels that may sufficiently pique interest. More tactical investors with shorter time horizons may want to hold off on buying fixed income, given the current bearish rate and spread momentum.
While 2022’s macroeconomic and market turmoil has resulted in negative total returns in most fixed income sectors, the widespread sell-off and continued volatility have opened up some attractive opportunities for fixed income investors with longer-term horizons. We remain vigilant and conservative, focused on the long-term view and keeping steady hands at the wheel.
1 Seasonally adjusted annual rate.
2 The difference between 3-month Treasury bills and 10-year interest rates in the United States.
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