Investors have enough reason to worry. Markets are volatile. Inflation is persistent. The risk of recession is looming.
But there is a silver lining: with yields now higher, we think bonds are attractive again.
In our last Cyclical outlook“Prevail under pressure,“We discuss the case for bonds, including greater income and diversification potential than in years, in our opinion. We also discuss other assets and analyze in detail the factors driving inflation, as well as monetary responses and recession potential.This blog post summarizes our views for the next six to 12 months.
The economic context
Geopolitical tensions, high market volatility and the fastest pace of central bank tightening in decades are contributing to an unusually uncertain economic environment.
Our baseline forecast calls for shallow recessions in developed markets, particularly in the Eurozone and the UK, which are facing disruption from the war in Ukraine. US real GDP will also likely experience a period of slight contraction.
Meanwhile, core inflation rates that are above central bank targets now appear more entrenched, and while headline inflation is still likely to moderate significantly going forward over our cyclical horizon, this now seems likely to take longer.
The combination of higher unemployment and inflation stubbornly above target has put central bankers in a tough spot, but their overall actions to date suggest they are focused squarely on bringing inflation down. . In the United States, for example, we expect the Federal Reserve to raise its key rate to a range of 4.5% to 5%, then pause to assess the impact on the economy of its tightening.
With higher yields across all maturities, we believe the case for investing in bonds is now stronger. We believe that high-quality fixed income markets should now generate returns much more in line with long-term averages, and we believe that the start of yield curves in most markets already price in sufficient monetary tightening.
We see many opportunities to exploit this growing value in the bond markets. For example, investors could combine exposure to high-quality benchmark yields – which have increased significantly over the past year – with selective exposure to high-quality spread sectors, and add potential alpha through active management. We believe the return potential is attractive given our cyclical outlook and that many investors could be rewarded by returning to fixed income.
Additionally, in addition to higher income potential, yields are high enough to offer the potential for capital gains in the event of weaker than expected growth and inflation outcomes or more pronounced market weakness. scholarship holders. We expect more normal negative correlations between high quality bonds and equities to reassert themselves, improving the hedging characteristics of high quality core bonds, which should generally rise in value when equities fall. Additionally, the higher yields offered in bond markets today could help offset those who choose to wait out this period of uncertainty and potentially higher volatility.
Nonetheless, caution is warranted, and if inflation is more sticky than expected, central banks could be forced to raise rates more than currently expected, and if recessions are as shallow as expected, policymakers could be slow to reduce policy interest rates to stimulate growth, given the high starting point of inflation.
So in core bond portfolios, this is an environment in which we are willing to make the active and deliberate decision to reduce risk on a range of risk factors and retain some dry powder (that’s i.e. maintaining liquidity). Liquidity management is always important, but it is especially important in a difficult and highly uncertain market environment. Consistent with our secular outlook, we will seek to maintain portfolios that will be resilient across a range of economic, geopolitical and market outcomes.
We share our views on other assets in the Cyclical outlook, but we make one last point here: we believe that the anticipated real volatility of the economic and financial markets will create attractive opportunities for investors who demonstrate patience and fresh capital. The gap between private and public asset valuations remains extreme, but as private markets adjust and challenges become apparent in the corporate credit and real estate space, opportunities should arise for potentially generate outsized returns. This is one of our most compelling opinions.
All investments contain risks and may lose value. Invest in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation and liquidity risks. The value of most bonds and bond strategies is affected by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity can contribute to reduced market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Goods contain increased risks, including market, political, regulatory and natural conditions, and may not be suitable for all investors. Shares may decrease in value due to real and perceived general market, economic and industry conditions. Invest in securities denominated and/or domiciled abroad may involve increased risk due to currency fluctuations, as well as economic and political risks, which may be increased in emerging markets. Exchange rate can fluctuate significantly over short periods of time and reduce portfolio returns. Mortgage and asset-backed securities may be sensitive to changes in interest rates, subject to prepayment risk, and although usually backed by a government, government agency or private guarantor, there can be no assurance that the guarantor will perform its obligations. References to agency and non-agency mortgage-backed securities refer to mortgages issued in the United States. Inflation-linked bonds (HE B) issued by a government are fixed income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs lose value when real interest rates rise. Treasury Inflation-Protected Securities (TIPS) are ILBs issued by the US government. Private credit involves investing in unlisted securities which may be subject to liquidity risk. Portfolios that invest in private credit may employ leverage and may engage in speculative investment practices that increase the risk of investment loss. Diversification does not insure against loss.
Alpha is a measure of performance on a risk-adjusted basis calculated by comparing the volatility (price risk) of a portfolio against its risk-adjusted performance against a benchmark; the excess return over the benchmark is alpha. Beta is a measure of price sensitivity to market movements. The market beta is 1. Roll down is a form of yield that is realized as a bond approaches maturity, assuming an upward sloping yield curve.
The terms “cheap” and “rich” as used herein generally refer to a security or asset class that is deemed to be materially undervalued or overvalued relative to both its historical average and expectations. investment manager futures. There is no guarantee of future results or that the valuation of a security will ensure profit or protect against loss.
The credit quality of any particular security or group of securities does not guarantee the stability or safety of an overall portfolio. Quality ratings of individual issues/issuers are provided to indicate the creditworthiness of those issues/issuers and generally range from AAA, Aaa or AAA (highest) to D, C or D (lowest) for S&P, Moody’s and Fitch respectively.
Forecasts, estimates and certain information contained herein are based on proprietary research and should not be construed as investment advice, an offer or solicitation, or the purchase or sale of any financial instrument. Forecasts and estimates have certain inherent limitations and, unlike an actual performance record, do not reflect actual transactions, liquidity constraints, fees and/or other costs. Further, references to future results should not be construed as an estimate or promise of results that a portfolio of clients may achieve.
Statements regarding financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work in all market conditions or are suitable for all investors and each investor should assess their ability to invest for the long term, particularly during periods of market decline. Investors should consult their investment professional before making an investment decision. Outlook and strategies are subject to change without notice.
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Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.