A fixed income roadmap for 2023
From the early days of Ronald Reagan’s first term in the White House, the bond market was in rally mode with only brief interruptions as falling yields drove fixed income prices higher. While a reversal of fortune was likely inevitable, few knew at the start of 2022 that the 30-year rally would come to such a violent end.
“Fixed income returns we’ve seen over the past year are close to the worst on record,” said Neil Sutherland, portfolio manager at Schroders. On the bright side, bond prices have fallen and yields are up. “This suggests that we are looking for better values than what we have seen for some time,” he adds.
That’s not to say fixed income investors should expect smooth sailing. Although we will likely see inflation fall from recent highs, it will be some time before we know how quickly price pressures will subside, and just as importantly, by how much.
If inflation tends to fall back below 5% this winter, the Federal Reserve may not need to raise interest rates as high as some have feared. This could help pave the way for a proverbial “soft landing” for the US economy.
What would constitute a soft landing? Unemployment rates, which are currently below 4.0%, would increase to between 4.5% and 5.0%, but not more, and this rate could support current levels of consumer spending. And in such a soft landing/modest recession scenario, companies would be more likely to maintain their capital spending plans while keeping layoffs to a minimum.
Still, inflation has remained stubbornly persistent, notes Scott Barnard, portfolio manager at Westwood. If metrics such as the consumer price index do not show a steady decline, the Fed may need to raise interest rates for a longer period, perhaps to the point that economic activity contracts in a deep recession.
Rapidly rising global interest rates are already disrupting markets as diverse as housing, autos and pensions. Under these circumstances, the likelihood of “something breaking” increases dramatically, Barnard says. “Look at the UK”
Last month, the Bank of England was forced to inject liquidity into the bond market after UK pension funds deploying so-called liability-driven investment strategies were hit by margin calls. In addition to these challenges, Sutherland adds that “the soaring dollar can also have unintended consequences in the bond market.”
If the economy and markets continue to weaken, investors will also need to consider the “Misery Index”, which combines the inflation rate and the unemployment rate. Bond management firm PIMCO noted in a recent outlook for the year ahead that a rising misery index would portend “a stagflationary shock that will likely hamper the US economy at a time when it is also facing the one of the most rapid tightening of financial conditions since 2008”. financial crisis, generally weak consumer and business sentiment and high uncertainty. All of this raises “the risk of a harder landing for the US economy.”
Sutherland thinks it will be quite difficult for the Fed to engineer a “soft landing.” In the event of a severe recession, Barnard believes longer-dated bonds would rally significantly as growth and inflation expectations begin to decline.
Missing inflation isn’t the only reason the Fed’s credibility is in doubt. At the start of 2022, the central bank forecast that real GDP in the United States would reach around 4.0%. Now that figure appears to be closer to 1.0%, Barnard says.