The last 12 months have delivered the worst returns for fixed income in decades – worse than the famed 1994 selloff, and on par with the worst episodes of the late 1970s and early 1980s.
Both central banks and markets underestimated the extent to which inflation would increase – a result of a powerful combination of pandemic-related supply issues, the disruption to energy markets due to the war in Ukraine, and strong pent-up demand supported by loose fiscal and monetary policy. The surge and the broadening of inflation has forced central banks to raise official interest rates much faster and further than they anticipated, and markets to reprice bond yields higher and prices lower.
2023 promises to be a much different year:
- Firstly, inflation will moderate. Headline inflation in particular should move lower as supply chains and goods markets normalise (to a degree), and demand-driven price pressure should ease in response to tighter policy.
- Secondly, growth will slow, perhaps significantly. The effect of slowing growth in 2022 was overshadowed by the acceleration of inflation – which actually drove nominal growth up. This year, slowing growth – in both real and nominal terms – will be a much more important influence.
- Thirdly, the policy cycle will mature. The rate hikes will end, likely before mid-year, and quantitative tightening will mostly be complete by year end.
With the inflation and policy shock waning, 2023 would seem to be a more pleasant year for markets.
This may be an illusion, however, as:
- Labour markets remain very tight, presenting continued upside risk to core inflation.
- While inflation and interest rate risk is likely mostly priced, recession and weakening corporate earnings risk is not. Markets are banking on a ‘soft landing’ or mild recession, but these are very rare, especially as this policy shift has been so abrupt.
- Markets are still grappling with a large transition in liquidity risk as central banks reduce the size of their balance sheets. This showed up in isolated incidents in 2022, such as the Gilt and FTX meltdowns, but reduced liquidity could keep asset volatility higher, even if macroeconomic volatility subsides.
Together, this set up for 2023 suggests a good year ahead for high-quality bonds.
The key arguments are:
- Firstly, that after the repricing, fixed income offers significantly better value. The jump in yields means prospective through-time returns will be higher. And at current yields, we assess that government bonds are ‘cheap’ both on an absolute basis given medium-term economic inputs, and on a relative basis to equities and other assets. Similarly, high-quality corporate bonds are ‘cheap’ relative to the likely range of default stress scenarios.
- Secondly, the cycle is turning in favour of bonds. Bonds are now worth owning simply for their higher yields – i.e. higher ratios of income to price – and the improved value this represents. However, the shift in the balance of risks from upside inflation to downside growth means there’s a decent probability we will see bond prices rise, lifting total returns.
Positioning
As discussed above, we think most of the interest rate re-pricing is complete. In conjunction with our assessment of underpriced recession and liquidity risk in riskier assets, this makes high-quality bonds, both government and corporate, very appealing sources of low-risk income and diversification over medium-term investment horizons. Australian investment grade credit stands out as particularly appealing, given its high risk-adjusted spread.
Our strategy is to steadily accumulate high-quality assets at good levels, being patient to wait for better opportunities in riskier assets. While eventually the downside risks to growth are likely to dominate market pricing, these may not eventuate for some time. This suggests we should embrace the good income on offer now in high-quality assets, and be flexible and prepared to firstly increase interest rate duration and later to add to riskier assets.
Our current portfolio settings are:
- Neutral to small long interest rate duration. We are long in the US and Australia, and short in regions where policy tightening is lagging, namely Europe and Japan.
- Overweight short-dated and underweight long-dated bonds in the US and UK. These positions will benefit from yield curves steepening from significantly inverted levels, which will occur when markets move to price in the next down cycle in interest rates.
- Moderately overweight investment grade corporates, mostly in Australia. This asset class is offering good value and should be insulated, should credit conditions deteriorate. We also continue to run a small weighting to Australian residential and commercial mortgages.
- Low weightings in riskier credit. We retain small positions in Asian credit and EM sovereigns, given attractive pricing, and small exposure to Australian subordinated debt, paired against a derivative short position in US high-yield.
With fixed income now standing out to us as offering good absolute and relative value, and the cycle potentially turning in favour of bonds, we are confident 2023 will look significantly different for the asset class. We have moved to position constructively in interest rate duration and high-quality corporate debt, and expect to become even more constructively positioned through the year.
