Outlook 2023: bonds are back

While interest rates are still rising and inflationary pressures are still acute, there are more encouraging signs in the year ahead. The Fed has already likely done most of the heavy lifting by raising rates significantly in 2022 and markets are now only pricing moderate increases in 2023. During the year, the US central bank is likely to pause on the hiking cycle, although markets do not anticipate falling rates until towards the end of the year.

This pause will only be possible if inflationary pressures show signs of fading. While there is a long way to fall to the central bank target of 2%, the last five inflation readings in the US have steadily fallen from the 9.1% reading for June. While the Federal Reserve continues to reiterate its commitment to price stability, eventually the pressure to raise rates will dissipate. The Federal Reserve may also be influenced by weaker economic data as recessionary forces start to bite.

This should be a more favourable backdrop for bonds. Fixed income markets are likely to anticipate the turn in the cycle ahead of time. Yields offered by bonds also look significantly more attractive than at any point in the last decade. The US 10-year treasury yield, for example, is at its highest level since 2010. The yields on most developed government bonds are now above the forward-looking inflation measures. This raises the possibility that, in a marked change from much of the previous decade, fixed income may once again offer the prospect of positive above-inflation returns.

That said, there are still risks. Policymakers can always make an error, as was seen in the UK’s ‘mini-budget’ of September 2022. Global economic growth may prove stronger than expected, particularly if China’s reopening boosts activity. As such, any investment in fixed income needs to be mindful of these risks.

Given our expectations that we may be nearing the end of central bank tightening, we are starting to consider longer-dated bonds, which have more sensitivity to interest rates. We continue to prefer US treasuries to UK gilts, where we are concerned about the amount of issuance required to support government funding. The gilt market may be relieved that the Liz Truss administration was short lived, but estimated issuance remains high in the future. If buyers for new gilt issuance prove elusive, it may push yields higher. While there are some risks around the currency, US Treasuries have the benefit of perhaps being regarded as the world’s ultimate safe-haven asset and have performed better historically during periods of market stress.

Inflation-linked bonds offer a hedge against stickier inflation. While inflation is likely to fall from here, there is a risk that markets are being overly optimistic and it does not fall as quickly as expected. Higher wage demands, deglobalisation and the shift from efficient supply chains to more resilient supply chains are all likely to support higher prices.

Within corporate bonds, High yield would be particularly vulnerable in a worse-than-expected recessionary environment and while default rates are currently very low, certain sectors are likely to see them rise as household spending is squeezed and the cost of borrowing goes up. Consumer discretionary companies and leisure/retail look vulnerable, for example.

Investment grade is likely to prove a more fertile area for investors. Yields are high, but defaults are likely to remain low. Issuance has come down as borrowing costs have risen, which creates a more favourable supply/demand balance. We are focused on shorter-dated bonds, given yields are attractive in comparison to government bonds.

The final point worth noting is that the inflation shock has driven an increasingly positive correlation between equities and bonds. That shock now appears to be moderating. With concern shifting towards the strength (or otherwise) of economic growth, we would expect this correlation to decrease, and the diversification benefits of holding bonds in portfolios to return.

2022 has undoubtedly been a tough year for fixed income and inflationary pressures have not gone away. However, investors are well-compensated for the risks they are taking, with yields at decade highs and the bad news on interest rates largely reflected in market pricing. Fixed income may be able to resume its traditional role in a portfolio, providing income, capital stability and diversification.

Source

All figures stated are sourced from Refinitiv/ Evelyn Partners