It will be a tricky road ahead, but interesting opportunities are opening up as some of the pressures faced by bond markets are starting to ease.
High inflation and an aggressive response by central banks led to a challenging 2022 and poor performance among many asset classes. However, there are a number of reasons why bonds are becoming increasingly attractive and we are expecting to see greater investor demand for fixed income in 2023.
Firstly, there are signs that inflation pressures are easing, led by US disinflation.
Secondly, slower growth dynamics – particularly in the US.
Thirdly, central banks are closer to ending their rate hiking cycles, particularly those economies with a greater sensitivity to higher interest rates.
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Lastly, bond valuations are attractive, with yields a lot higher relative to a year ago.
We have no doubt that these factors will open up interesting opportunities across global fixed income markets.
Inflation pressures are easing
Higher inflation complicated the outlook for bonds in 2022, but there are encouraging signs as we head into 2023. Goods inflation has been a leading indicator of the rise in inflation over the past 18 months, and we are beginning to see clearer evidence of this going into reverse – the so called “bullwhip” effect we have been expecting.
While indicators such as global shipping costs and ISM/PMI surveys have been pointing to this dynamic for a while (chart 1), we are now finally beginning to see it reflected in official inflation measures (chart 2), and we believe this can continue further as we head into 2023.
Chart 1: Survey indicators point to further disinflation ahead
Chart 2: And official inflation data is now beginning to reflect goods price deflation, which we expect to continue
Though we believe that the path to target inflation of 2% may ultimately prove difficult due to stickier services inflation, the relatively rapid initial improvements we expect to see in the first half of 2023 should be greeted very warmly by markets. This will lead to a more favourable backdrop for global bonds, lower bond volatility, and opportunities in assets such as selective emerging market local currency debt and emerging markets (EM) foreign exchange (FX).
Tighter financial conditions contributing to slower growth still to be felt
We remain concerned that the impact of the financial conditions tightening we have seen throughout 2022 has not fully reflected in key economic data. The more lagging indicators, such as consumer spending and in particular the labour market, still remain very resilient despite sharply weakening leading indicators, such as housing.
Our expectation is that over the coming months we will see clearer signs of the tightening of financial conditions impacting growth, especially in the US. This will encourage central banks to pause further tightening and to reassess the situation.
This will be positive news for global sovereign bonds. However, it leaves a more conflicted picture for cyclical assets such as corporate bonds, with the tailwind of lower inflation and bond volatility meeting the headwind of the impact of a weaker economy on company earnings – a recipe for a choppy outlook.
Chart 3: Financial conditions tightening already delivered implies further downside risk to economic growth
Economic divergence to present cross-market opportunities
It is not all doom and gloom, however. While we believe the lagged impact of financial conditions tightening is yet to fully play through, especially in the US, and will become more apparent in 2023, there are growing signs that other major economic headwinds may be reducing in intensity.
Although we do not believe that the gas and energy crisis facing Europe is over, there are grounds for cautious optimism that the worst of the crisis may have peaked. This lull, if maintained, would imply a more moderate decline in activity than was otherwise feared.
For forward-looking financial markets, this is crucial. We believe it could lead to underperformance of German bunds on a cross-market basis against US Treasuries.
Chart 4: While prices are still high, there’s been a significant improvement in European energy outlook
China re-opening an additional facet of support for Europe
Market participants have been taken aback in recent weeks by the speed of the change in Covid strategy from China, where we are seeing many signs of a faster pivot away from zero-Covid than had been anticipated. Moreover, incrementally there have been supportive measures for the beleaguered property sector, a crucial driver of growth in every economy, but especially in China.
However, there remains a high degree of uncertainty of both the speed and scale of the change in Chinese policy towards Covid and property in the first half of 2023. Given the very negative sentiment towards and poor year-to-date performance of assets linked to the Chinese economic cycle (such as Asian FX), we believe the bar for investors to be positively surprised remains low.
We favour expressing this with more positive views on selective commodity and Asian currencies. It is worth noting though that any improvement in the outlook for China would also provide significant benefit to Europe.
Hiking cycles curtailed in the more interest rate sensitive economies
Finally, we remain concerned that the speed and scale of global tightening will have ramifications in those economies where household debt and house price to income ratios are high. This might lead to a reduced ability for central banks in these economies to tighten policy before consumer and housing vulnerabilities derail them.
We believe this provides significant relative value opportunities, to be long on a cross-market basis the bonds of the most vulnerable countries (Sweden, Canada, UK) against those less exposed (US and Europe), or alternatively to be short the currencies of these more vulnerable nations.
Chart 5: Housing vulnerabilities appear high in Sweden, Canada and UK
All in all, 2022 has proved a difficult year for capital markets, but the market pain has led to higher yields and a very attractive environment for fixed income from a valuation perspective.
As always, timing is important. Once market participants begin to put less weight on inflation – for the reasons mentioned above – and engage with the deteriorating growth backdrop, there will be very good return potential realised across global fixed income markets. Indeed, greater signs of disinflation and the threat of inflation receding is exactly what bond investors need to see.
Importantly, we are also expecting bond volatility to come down as hiking cycles mature, which will be welcomed by investors.
Originally published by Schroders – Authors: Paul Grainger, Head of Global Fixed Income & Currency and James Bilson, Fixed Income Strategist.