Despite the challenging yield environment in 2022, investors are now getting more income from their fixed income than they have in years. Yields will respond to changes in the growth and inflation outlook, and closely watching key indicators we believe will help short-term investors find attractive entry points for buying fixed income.
This year has been challenging for fixed income investors with yields rising dramatically year to date, translating to some of the worst total returns across fixed income in decades. The yield on the 10-year US Treasury has more than doubled from 1.5% on December 31, 2021 to over 3% today. Over this same time period, the yield on investment grade (IG) corporates has risen from 2.3% to almost 5.0%, and the yield for high yield (HY) has jumped from 4.2% to over 8.0%. While price returns have been painful, investors are now getting more income from their fixed income than they have in quite some 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.
Figure 1: Yield Levels Look More Attractive Today Relative to Long-Term History
Structural Headwinds Reinforce a Low- Growth, Low-Yield Narrative — So Far
Cyclically, we are in the early stages of a monetary policy tightening cycle with inflation persistently high — with headline Consumer Price Index (CPI) over 8% year-over-year (YoY) and with the Federal Reserve raising rates and starting quantitative tightening. Yield momentum therefore remains bearish in the shorter term. However, long-term structural indicators thus far point to a growth and rate environment continuing to be anchored to the downside by slow labor force growth and slow productivity growth, including the largest contraction in productivity in 75 years in the first quarter (down a -7.5% quarter-over-quarter, seasonally adjusted annual rate).
Figure 2 : Headwinds for Trend Growth and Sustainably Higher Yields
Historically low labor force and productivity growth continue to be headwinds for trend growth and high yields. Labor force participation is a major factor driving the picture above (Figure 2). 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. Where will this rate settle longer term?
Cyclically we believe that more likely than not, inflation is near its peak YoY level of over 8%. Some relief from upward inflationary pressures should stem from incremental improvements happening in supply-side challenges, as well as the Fed rate hikes tightening financial conditions which are expected to dampen economic activity on the demand side. In order for inflation to remain sustainably at current levels, we would need to see meaningfully higher moves in long-term inflation expectations, which had remained well anchored until the most recent print which showed a slight uptick. The latest University of Michigan survey recently released found that the median respondent projects inflation to rise 3.3% on average over the next 5–10 years. This represents an increase of only approximately 60 bps in long-term expectations over the past 12 months, during which time YoY CPI inflation has doubled from 4.2% to 8.3%.
Figure 3a: Labor Force Participation Has Not Recovered to Pre- Pandemic Levels — When Will It?
Figure 3b: Long-term Inflation Expectations Had Remained Well Anchored Until a Slight Uptick in June
There are good reasons to believe these trends may change moving forward, but regardless of one’s specific stance on the direction of these trends, these charts show that the story has not changed much compared to pre-pandemic times. Strategic investors with longer time horizons may want to consider buying fixed income given the back-up in yields and structural picture.
Cyclical Considerations: What to Watch for
More tactical investors with shorter time horizons may want to hold off on buying fixed income given the current bearish rate and spread momentum. The Fed’s strongly hawkish rhetoric may change in the coming months, but not as long as inflation remains far above the 2% target. Here we would suggest monitoring short-term cyclical indicators related to inflation dynamics and economic activity.
On the inflation front, we are carefully watching for signs of additional relief in supply chain stress. While the picture is far from normal, there is no question that additional progress is being made in resolving supply-side issues, which continue to put upward pressure on prices.
Figure 4 : Clear Improvements in Supply Chain Stress Index
On the economic activity front, we are monitoring consumer dynamics closely. Fiscal stimulus-driven spikes in income and savings rates in 2020–21 left the US consumer in a relatively healthy financial position. As stimulus fades further into the rearview and high inflation has taken a bigger bite out of real incomes, we expect consumer demand to slow from its current high levels, particularly with respect to goods consumption.
Figure 5a : Normalization of Goods and Services Consumption Patterns and Incomes Plus a Tightening Fed Should Help Slow Demand in the Coming Months
Figure 5b : Comparison of Personal Income Levels and Goods Consumption
Our base case is that inflation and growth ease in the coming quarters and that 2023 measures will be much closer to long-term averages than 2022 measures. The path to that point, however, will be uneven. Yields will respond to changes in the growth and inflation outlook; watching the indicators we have discussed here, among others, will help shorter-term investors find good entry points for buying fixed income.
Investment horizon matters. More strategic investors with longer time horizons should consider buying fixed income. Income-oriented investors are now able to get significantly more yield. Corporate defined-benefit pension plans will want to take the opportunity to liability hedge given high-funded ratios. Even public pensions can get near their target long-term returns with diversified fixed income allocations. More tactical investors with shorter time horizons, however, should watch cyclical developments and market technical elements to pinpoint when it will be a good time to buy fixed income.
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