The economic outlook looks positive and bonds are well positioned for strong, long-term performance, compensating investors for risk, explains Robert Tipp, chief investment strategist at PGIM Fixed Income.
Yield, of course, is the lynchpin for bond returns. The markets’ newly – and quickly – rediscovered high yield levels have effectively turned the clock back two decades, setting fixed income up for strong returns over the long term, notwithstanding periods of volatility to come.
However, this year’s volatility will likely be no more than speed bumps in the start of a bull phase as the newly re-elevated income stream ultimately powers bond returns through these events.
While cautiousness about the outlook is certainly warranted, it is worth considering the confluence of factors that crushed fixed income returns over the last several quarters – low starting yields, strong growth, high inflation, central bank rate hikes, and energy supply concerns – are arguably turning into tailwinds. Whereas 2022 started with very little yield to cushion against adversity, yields are now at historically respectable levels.
The incredibly strong growth in the first half of 2022 has given way to a moderate pace. Meanwhile, inflation prints are finally returning to earth, with both concurrent and leading indicators promising lower inflation numbers ahead. In contrast to last year, not only have most DM central banks notched substantial rate hikes, but markets have priced in more hikes to come. The shift in fundamentals to bond positive suggests the taper-tantrum type of damage to the rates and spreads markets is largely behind us.
Focus turns to extending the expansion
Although growth momentum is clearly slowing, this may prove an ironic positive for credit products. The 2022 rout in spreads and equities, just like the taper tantrum in 2013 or the rout of 2018, revealed that the biggest threat to risk appetite is simply the fear of monetary policy tightening, higher interest rates, and the negative spill-over into credit spread widening.
Just as those bearish cycles were followed by strong spread market performance once rates stabilised, during the recent bear market, spreads similarly tightened whenever the rates’ selloff abated. Therefore, as the developed market central banks bend their course, signalling the slowing and the ending of their rate hike cycles, spread products should perform well as central banks’ focus turns from fighting inflation to extending the expansion.
In contrast to most cycles where the bear market increase in rates is followed by a quick, round-trip drop, this cycle may be different, ending with an interest-rate plateau rather than the typical up-and-down pattern. The most salient reasons for this cycle’s difference are that with unemployment low and inflation high, central bankers will be reticent to ease monetary conditions, fearing a resurgence of inflation. A second reason is that rates may not need to fall. In the wake of the global financial crisis (GFC), financial policies have been prudent, leaving this cycle absent of the kinds of asset bubbles and overleveraging that have historically necessitated big drops in rates.
Rates are in the vicinity of a peak
As economies lumbered through the GFC and the consequent doldrums, the Reinhart-Rogoff study of the day highlighted how banking crises have historically been followed by several years of economic malaise, where central banks keep rates low to facilitate an economic recapitalisation. Pro-cyclical tightening in the US and in Europe likely extended these periods of subdued economic growth. But now, the bad debt overhangs are gone, financial institutions are well-capitalised, and pro-cyclical fiscal tightening is behind us. As a result, DM economic expansions may continue – even with rates back up at levels seen before the GFC. While this ‘back up to normal’ hypothesis may sound speculative, we will get an answer in relatively short order.
In summary, the rates outlook appears finely balanced. Yes, further central bank policy tightening is in the offing. But fundamentals appear to be turning for the better, with both growth and inflation moderating, suggesting rates are in the vicinity of a peak. Scope for rates to fall, however, is likely limited given central banker fears of resurgent wage pressures and low levels of unemployment.
True, the investment horizon remains clouded, and anxiety is running high. But as compensation for risk, yields have swung from their unprecedented 2020 lows all the way to the high end of their range of recent years, leaving bonds well positioned for strong, long-term performance.
*Robert Tipp is chief investment strategist at PGIM Fixed Income.
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