Fixed income outlook: Is the market overly hawkish?
After the bond bear market of 2021, valuations look more attractive in an environment where interest rate rises may already be priced in.
Inflation to normalise
Whilst the Fed has moved to speed up ‘tapering’ (i.e. buying less bonds), which has brought forward the expectation of interest rate rises in the US, we remain reasonably sanguine about the inflation outlook. Without question we are seeing very high inflation prints and this could well continue today and over the coming months – in many cases reaching the highest inflation we’ve seen in many decades. However, our analysis concludes with the view that elevated inflation will not be permanent and is currently present for well-documented and fairly understandable reasons – albeit it has been higher and has lasted for longer than we expected.
Initially the base effects (year-on-year) took hold with oil and other commodity prices bouncing significantly higher than from the depressed levels from 2020. The supply side shocks have probably come as an upside surprise contribution to inflation given the various global lockdowns, which still continue (unfortunately) at the end of 2021, given the emergence of new variants. On the other side of the equation, we have seen strong demand from a combination of economies unlocking, pent-up savings rates, fiscal stimulus and, lastly, the shift in demand from capital goods to services, which have all contributed to the high inflation. However, we are already seeing a number of these supply and demand side effects coming down.
For us, the much longer-term deflationary impacts of the three well-documented forces of globalisation, ageing demographics and automation/technology – the last of which has been much enhanced due to the pandemic – should continue to weigh on inflation over the coming years, bringing inflation back down to a ‘normalised’ 2% globally, which is very much where central banks have targeted, and often failed, to reach since the global financial crisis. This level of ‘normalisation’ to a much lower inflationary environment than we have become used to since the pandemic could provide some market volatility over the coming year.
Reasons for optimism
Despite this backdrop, we are still confident of delivering attractive risk-adjusted returns in our global unconstrained fixed income strategy. Our strategy benefits from a very wide investment universe which we use to provide diversification and this, as well as the flexibility afforded to us through active management, have been very useful tools once again in 2021 in something of a bear market for many fixed income markets. Despite the bear market, we have been mainly focused on capital protection and are sitting on a flat return year-to-date, whilst many bond markets have delivered negative returns.
There are two important factors for considering optimism in fixed income returns as we head into 2022. First of all, many parts of the bond market have already priced in interest rate rises and the end of Quantitative Easing (‘QE’), to the extent that we think that the market might be overestimating the number of rate rises, potentially leading to opportunities in high quality bonds.
Secondly, if we look at the behaviour of the US treasury market in 2021, which is much lower in yield that many would have expected, this suggests to us that there are still very powerful, sometimes price insensitive, buyers of government bonds – be it global QE, pension funds or regulatory-driven investors – which is a phenomena that we have seen for many years and which will continue to put something of a cap on yields.
Flexible duration management
In 2021, we have at times held a very low duration exposure but then, perhaps contrarian to many investors, have also found opportunities to increase our duration to higher levels, which has benefitted our strategy’s performance. Being structurally short duration, or even negative duration, does not strike us as a strategy that will bear fruit in this environment. On top of that, we have benefitted from a high allocation to inflation-linked bonds in 2021, which have positively contributed as inflation breakevens have widened.
More recently, however, we have seen valuation reasons to reduce that allocation for the time being, despite the current high spot inflation, and have a more cautious view for the coming months. Here, again, we benefit from our flexibility in being able to reduce our exposure to inflation breakevens, which has had a good run, whilst simultaneously adding to short duration high yield opportunities, which should continue to perform in the current environment. In fact, we have recently seen a pick-up in credit volatility which increases our optimism for making returns further down the credit curve over the coming quarters as valuations improve and the yield and carry on offer increases.
In conclusion, we see continued opportunities for high quality government bonds to contribute to diversified fixed income returns and believe an actively managed approach will continue to reap the benefits. Current market pricing for bonds has increased our appetite as we believe the market may in places be too hawkish. We would add to this a carefully selected basket of European financials and lower-rated US high yield names which, when put together, make up our main convictions for the year ahead.
Past performance is not a guide to future performance.