The beginning of 2022 has proven to be extremely challenging for the global fixed income markets. Investors, consumers, and businesses alike have had to deal with the strongest inflationary pressures in 40 years. These pressures have been made worse by a commodity price shock, geopolitical uncertainty resulting from the conflict in Russia and Ukraine, and tighter global financial conditions as a result of the switch to less accommodative central-bank monetary policies. While the market turmoil of this year has led to negative total returns across most fixed income sectors, it has also created lucrative opportunities for investors with longer-term time horizons.
Fixed Income Market Outlook – Key Insights for 2022
2022 has been a year dominated by volatility for markets. The root of this market volatility is attributed to inflation uncertainty, which has resulted in policy uncertainty. The U.S. Federal Reserve (“Fed”), which was once the leader of “team transitory”, is now shifting its strategy. Heading into the second half of the year, the direction of rate policy will have significant implications for market returns, recession risk, long-run inflation, and the durability of the 60/40 portfolio. Although the US Federal Reserve’s underlying hawkishness is still present, a turn is beginning to become apparent.
For the time being, it is anticipated that the Fed will keep up its front-loaded hiking cycle. The prospects of developed markets edging closer to a recession are becoming more likely as global macroeconomic fundamentals continue to deteriorate. The probability of a hard landing continues to be the base scenario. In order to re-anchor dangerously growing inflation expectations, central banks will end up pushing their respective economies into recession either accidentally or on purpose.
The Fed is continuously arguing for front-loading interest rate increases as it tries to bring inflation under control. On Friday, August 26th, at the Jackson Hole Economic Symposium, the Fed’s Chairman Jerome Powell ended speculation of a Fed lean towards cutting rates to aid the economic recovery in the short to medium term. To ensure stability in price, a restrictive strategy would have to be adopted for an extended period of time. The Fed Chairman confirmed that the department would utilize everything in its inventory to decrease inflation, which has elevated to a level that has not been seen in the past 40 years. Even with four consecutive interest rate increases, which totaled up to 225bps this year, Powell said that they will not stop.
Fed Chairman’s Comments Move Fixed Income Markets
According to Trackinsight’s fund flow data, Europe-listed fixed income ETFs attracted a total of USD$335 million of investor capital between August 22nd to August 26th, which means that this is the sixth consecutive week that has experienced net inflows, and the second week that has experienced average returns that are negative. Powell has been clear with regard to price stability and fighting inflation and was quoted saying that “The Federal Open Market Committee’s (FOMC) overarching focus right now is to bring inflation back down to our 2 percent goal.” He also stated that without price stability, the economy will not be able to achieve a sustained period of strong labor market conditions that benefit all.
Powell’s hawkish statement that restoring price stability will probably require maintaining a restrictive policy stance for some time, even at the expense of slowing economic growth, echoed across the markets with the S&P 500 falling from 4,197.16 to 4,057.99, a 3.32% drop and the largest for several months. On the fixed income side, U.S. Treasuries rose in anticipation of ever-increasing interest rates, and it is pertinent to note that the 2-year US Treasury jumped more than the 10-year Treasuries. Government Bond ETFs also reacted positively to the news attracting USD$350 million of net inflows, while in sharp contrast corporate debt ETFs lost US$195 million over the week across all credit ratings, the largest outflows in the fixed income sector.
From a credit rating perspective, investment grade bond ETFs took the major chunk of inflows, having brought in USD$850 million of investor cash. In comparison to this, their high-yield counterparts registered almost USD$118 million in net outflows for the same period.
Last week’s flow leaders included the iShares Core € Govt Bond UCITS ETF (IEGA). The fund was able to lure USD$85 million of net inflows, meanwhile holding funds of USD $3.8 billion of assets under management. The fund follows the performance of an index that is composed of Eurozone investment-grade government bonds.
Additionally, the Amundi Index Euro Corporate SRI 0-3 Y UCITS ETF (ECRP3) was attractive to European investors for the fourth consecutive week. It attracted USD$65 million of investor capital as compared to the previous week’s USD$0.5 million. ECRP3 allows its investors to have access and view of a range of investment-grade, euro-denominated bonds. However, it excludes issuers that are involved in alcohol, tobacco, gambling, military weapons, nuclear power, adult entertainment, civilian firearms, genetically modified organisms, thermal coal, and oil sands.
On the other hand, bond ETFs saw large outflows including the iShares Core € Corp Bond UCITS ETF (IEAC) and SPDR Bloomberg Emerging Markets Local Bond UCITS ETF (EMDD), losing USD$300 million and USD$113 million, respectively.
Vulnerability of the “Diversified” 60/40 Portfolio
Typically, when growth assets, like stocks, sell off due to an economic downturn, safer assets, like bonds, appreciate as investors seek stability. While stocks tend to suffer in a recession due to the decline in economic growth, bonds can rally because the US Federal Reserve typically cuts interest rates to support the economy. Bond yields decrease while bond prices increase when interest rates are reduced. This acts as a portfolio’s shock absorber, reducing the impact of dropping stock prices on overall returns. For many years, the basis of “diversified” 60/40 portfolios has been this stock-bond balancing act. A rising level of inflation, however, limits the Fed’s ability to support the equities markets by cutting rates, thereby rendering the “Fed put” ineffective.
Due to this perplexing combination, standard 60/40 portfolio investors are exposed. Bond prices have only increased while stocks have declined three times since 1929. Except for the years 1931, when Britain abandoned the gold standard (which resulted in falling equities but rising interest rates to protect the currency), and 1941, when the US entered World War II (leading to rising inflation and falling stocks), 1969 stood as the exception that proved the rule for reliable stock-bond diversification.
The reasons for losses in that period are similar to today, with rapidly rising inflation unleashing a Fed tightening cycle that eventually resulted in recession. That time showed how bonds may be a terrific stock diversifier, unless stocks are declining owing to inflationary worries.
Fidelity International
According to a report by Fidelity International on fixed income perspective, at the September 15th FOMC meeting, a 75bps rate hike is likely and the terminal rate might have risen to 4% from 3.25-3.5%, with any pivot, now pushed out later in the first half of 2023.
Given the extent of the debt in the system and the fact that quantitative tightening is still escalating, draining US$95 billion a month from its $9 trillion balance sheet, further tightening financial conditions, the monetary tightening by the Fed to re-anchor inflation expectations runs the risk of sending its economy into recession. The result will probably be looser policy to boost economic growth the following year. Given the global demand for US dollar debt refinancing, it is important to monitor dollar liquidity conditions under US quantitative tightening. This isn’t a prominent risk now and the Fed has tools to fight this.
According to the report, in core European bonds, we are also long duration. The European economy is in a difficult situation and is likely to enter recession soon, whatever the ECB does. Adding monetary tightening to the mix could accelerate the downturn, and authorities may reverse course sooner than the market might think. The report suggests that investors should prioritize protection in this recessionary environment. The report also highlights that Fidelity favors investment-grade bonds, where valuations remain relatively attractive, especially in Europe. After Powell’s remarks, investment grade yields scarcely changed, which may be an indication that hawkish sentiment has peaked. High-yield spreads, in contrast, have not yet fully accounted for the danger of a harsh landing. One-year defaults in US high yield markets, for instance, predict a default rate of just 2.3%, which is consistent with a fairly shallow recession.
According to the investment firm, now is the moment to play it safe and invest in investment-grade markets rather than high yields.
