Is the Bond Bear Over Yet?

Is the Bond Bear Over Yet?

Slower economic growth should trend inflation lower, providing a tailwind for fixed income in 2023.

With the end of 2022 approaching, many investors are asking themselves, “When is it all going to be over?” The war in Ukraine, high inflation, interest rate hikes? The answer is, unfortunately, “Not yet.” But we are hopefully getting closer.

As developed market central banks such as the U.S. Federal Reserve continue to tighten monetary policy, although at a slower pace, 2023 will start out much the same way 2022 is ending. Markets have been quick to get excited about the prospects of Fed tightening – which is still ongoing – coming to an end, even going so far as to price in some easing towards the end of 2023. Markets have not, however, been focused on the fallout from all this tightening. The answer is much slower economic growth, and likely a recession. That is not a good thing, but it should allow elevated inflation to trend lower and provide a tailwind for fixed income in 2023. If China fully reopens, it could provide a partial offset to this slower-growth scenario, but the prospects do not look promising given the current COVID situation and the Chinese government’s commitment to its Zero COVID stance.

Still, there are segments of the market that seem to be putting too much weight on a soft-landing scenario, which seems too optimistic given the pace, breadth and severity of the global tightening so far. As we move into 2023, the recent relief rally will be replaced by the realities of a slowing economy, and the current inflationary backdrop will initially set the bar for central bank easing very high. If we do end up getting some easing from the Fed, it would be in response to very poor growth – and that reality is not currently reflected in many areas of the market.

Given this outlook, we are comfortable tactically adding high-quality duration, but are still being somewhat cautious on higher-yielding credit and Emerging Markets. Credit spreads are tight given the growth prospects, but they may hold in better this time versus prior downturns. Plus, all-in yields are historically very high thanks to the rise in U.S. Treasury yields. As a result, more emphasis should be placed on the attractive carry in 2023, which is bolstering total return prospects. Finally, on a price basis, valuations are also more compelling, offering a better risk-reward tradeoff than in years past. There are opportunities to be had, and even though they need to be scrutinized against a much slower global growth scenario, we cannot overlook the fact that the 40% in a typical 60/40 balanced portfolio offers the potential for more yield again, particularly given the rise in U.S. Treasury yields.

In last year’s outlook, we highlighted the fiscal health risks that many countries faced coming out of the pandemic, with higher debt levels coupled with the prospect of slower economic growth to help service that debt. In 2022, we saw these risks fully start to materialize, and it wasn’t just Emerging Markets that had to face this harsh reality. The stresses in the United Kingdom proved that developed countries can be susceptible as well, and markets will no longer tolerate material fiscal slippage. More left-leaning governments, such as Brazil’s, are flirting with these risks right now and realizing how hard it is to push their spending agendas. The unfortunate fallout is that the ability to spend going forward will be severely hampered at a time when it’s really needed. This is the steep price of poor fiscal management in years past, and it also means slower global growth going forward when countries don’t have the means to stimulate their economies as much.

On the other hand, we also highlighted previously that there was a huge opportunity to attract capital for those countries willing to enact reforms and seriously address their fiscal shortfalls. In 2023, these risks and opportunities will again be very much on the minds of bond investors, and multilateral lenders will continue to be called upon to help bring debt levels onto a more sustainable path. Unfortunately, with bond yields much higher and growth prospects much lower, the task of achieving that goal has just been made all that much harder.