In this month’s article, we make the case for bonds. We believe markets are confronting peak inflation fear. However, we still expect it to trend lower through H2 2022. With early signs inflation may be peaking, a waning ability for central banks to ‘surprise hawkish’, and rising rates tempering growth, yields on 10-year domestic and US government bonds are now almost 3%, a competitive alternative to equities for the first time in years.
We are closing our long-held tactical underweight to government bonds. We fund this by trimming our overweight to short maturity and taking a more cautious view on high-yield credit as rates rise. Our recent review of expected asset class returns has also led to some changes to our strategic allocations, with increased allocations to government bonds at the expense of credit (with weights unchanged for cash, equities and alternatives).
Is inflation peaking? Have we reached peak inflation fear?
With inflation in the major economies printing between 7 and 9% in Q2 2022 (see the following chart) and all attention on sharply higher commodity prices, as well as tight jobs markets and global central banks turning ever-more hawkish, it’s easy to forget that a large (and yet unknowable) swathe of that inflation is a by-product of the pandemic. The amount of supply-driven inflation that can ‘drop out’ of measured inflation through H2 2022 will be critical to determine when (and if) central banks can shift efforts to regather their inflation-fighting credentials (likely via rapid-fire, mid-year rate hikes) and pivot toward at least reflecting on the risk of contributing to a recession through over-tightening.
While short-term inflation expectations have risen significantly, those that measure out to five and 10 years remain broadly contained in most economies, including the US and Australia. In contrast to the late 1970s and 1980s this suggests that the challenge of reversing actual inflation should not demand a recession. In other words, the inflation ‘genie’ is not quite out of the bottle.
Of course, there remains the risk that rising costs of living (via energy and food), as well as tight jobs markets driving up wages’ growth, could create an inflation spiral that proves hard to reverse. However, with central banks now tightening financial conditions quickly, we believe this risk is being mitigated. Indeed, recognising the drivers of the recent inflation upswing remains key to assessing the extent these forces may reverse over the coming year.
While the next few months will likely see significant increases in interest rates, with the Fed hiking 0.5% at its next two meetings, and the RBA 0.25% at each of its next three, we believe a combination of some moderation in global inflation pressures and signs that activity is slowing (here and offshore) should foster a period of less hawkish central bank comments. This should limit any further significant adjustment higher in government bond yields.
We are closing our underweight to government bonds
We moved near-maximum underweight government bonds in August 2021 when the US 10-year bond yield was around 0.50%. We halved that position in November 2021 and January 2022 as yields rose to 1.8%. At around 2.80% today in the US and 3.35% domestically, we now believe bonds across the curve reflect a significantly greater value proposition. Domestic government bonds also look relatively more attractive than global on current pricing.
Indeed, a yield of around 3% that investors can receive for a risk-free investment is now competitive vis-à-vis the dividend yields, earnings yields, or free cashflow yields that investors can generate by holding equities.
10-year bond yields have now risen significantly
Is global inflation nearing its peak?
Key inflation drivers and the extent to which they are shifting course
AS BCA Research noted, “month-on-month US core inflation has already peaked, 12-month US core inflation is about to peak, and demand destruction will ultimately pull down headline inflation too”. UBS expects UK and European inflation to be below 5% by end-2022. For Australia, greater inertia in wage setting and utilities prices suggests inflation will rise through 2022, peaking end-year at a lower level than elsewhere (see above chart).
Forward curves already pricing significant tightening
Both bond and equity markets have weakened sharply year-to-date in 2022 as central banks have reacted to persistent inflation surprises by becoming increasingly more hawkish. US Federal Reserve (Fed) Chair Powell said the Fed will “keep pushing” until there is “clear and convincing” evidence that inflation is falling, repeating guidance that two more 0.50% hikes are on the table for June and July. In Europe where rates are still negative, European Central Bank (ECB) President Lagarde noted that “in the near term, inflation and growth are moving in opposite directions,” and “it looks increasingly unlikely the disinflationary dynamics of the past decade will return.”
Key to assessing the value in fixed income markets is whether the outlook for interest rates is being appropriately priced. Prior to this year, bond markets looked ‘expensive’ because they did not reflect the risk that interest rates would eventually need to rise significantly (in part due to central bank support that has now been reversed). However, a rapid re-assessment of central bank rate hikes suggests much of that risk has now been removed and we see markets as having likely ‘overshot’ on excessive inflation and interest rate expectations.
As always, there remains uncertainty over whether current pricing for bond markets is currently ‘fair’. This can be partly mitigated by considering the likely end point or terminal rate for central banks in the current cycle. For example, the Fed considers 2.50% to be its current neutral position for, a similar view to that expressed by Reserve Bank of Australia (RBA) Governor Phillip Lowe. While there is less debate in the US over the Fed’s figuring, in Australia both UBS and CBA believe neutral is much lower at around 1.25% due to the level of domestic debt. In contrast to the consensus for the RBA cash rate to rise to 2.0%, both CBA and UBS forecast a peak of only 1.6%.
While cash rates currently remain well below these levels, when we consider the expectations that are now priced into fixed income markets for central bank policy rate increases, they appear to more than adequately accommodate these significantly higher levels:
Australia—From an RBA current cash rate of 0.35%, market pricing puts the cash rate at 2.51% by end-2022 (a hike at all seven remaining meetings and 0.50% hikes at two of them), rising to 3.18% by October 2023. Such pricing exceeds economists’ forecasts and also provides some buffer to the upside should the RBA deem restrictive policy is needed.
US—The Fed policy rate has risen to an upper bound of 1.0% at the May meeting. Current market pricing has the policy rate rising to 2.53% at the end of 2022 before a further rise to 2.95% in 2023. This exceeds the 2.5% peak of the cash rate’s last cycle (but not the 5.25% peak in 2006-07), already factoring in the need to move policy to be modestly restrictive.
EU—Few, if any, predicted the ECB would be hiking rates in 2022. Yet, from a policy rate of -0.5%, expectations are that it will hike three times in H2 2022 to 0.25% before a further 1% hike to 1.25% in 2023. The last time the ECB policy rate exceeded 1% was prior to the GFC in 2008.
We are also starting to see bond yields rally when equities fall—unlike in Q3/Q4 2021 and Q1 2022. This suggests that bonds can (again) provide liquidity, diversification and yield should economic conditions and returns be worse than expected going forward.
As such, this month we are closing our underweight to government bonds (from -2 to 0). Within fixed income, we continue to favour short maturity assets but have reduced exposure to this area of the market (from +2 to +1). We particularly favour floating rate exposures and investments in the one to three-year part of the curve, where rate hikes have been factored in. While credit spreads have widened significantly this year, we remain cautious about credit, particularly sectors that are likely to feel the brunt of interest rate increases, such as property development. As such, while we continue to believe economies can avoid a recession, we have moved further underweight high-yield credit, which is likely to be the most vulnerable to rising stress as financial conditions tighten and economies slow.
Our recent review of asset class return expectations has also led to some reweighting of our strategic asset allocation weights (see page 17). We have increased our allocation toward government bonds at the expense of credit (with no changes to weights for cash, equities or alternatives).
Strategies for adding fixed income exposures
The recent rise in bond yields provides an opportunity to revisit fixed income exposures in portfolios. Tactically, we are now more positive on government bonds. Strategically, for those that have allowed their allocations to government bonds (and fixed income generally) to drift below benchmark, a more attractive return outlook now represents an opportunity to begin rebuilding those positions. The removal of significant prior duration risk should allow investors to enjoy the (defensive) diversification and liquidity benefits that fixed income can bring to portfolios.
For portfolios that have existing positions in (liquid) credit and high-yield strategies, this is a good time to trim. At the same time, a greater emphasis can be placed on cash and/or government bonds, which would allow investors to benefit from both liquidity and yield whilst waiting for future opportunities in areas such as private credit.
Whilst we expect that global growth will be at trend or slightly above, it is reasonable to expect ongoing volatility in markets as economies and investors continue to digest the impact of rising inflation and interest rates. Nor will inflation likely moderate back to the lows of the past decade.
We believe that the key to successful long-term performance is a well-constructed strategic asset allocation, and within that framework, diversification and active management are key portfolio management tools to ensure that there are no unintended under and over-exposures to markets, sectors and specific return drivers (e.g. region/country, industry, growth, value, or credit rating).
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