Opportunities arise as central banks yield to the inevitable

We may have entered Q3, but ask Jerome Powell or Christine Lagarde what their three priorities for 2022 are and they would say, without hesitation: “inflation, inflation and inflation”. In the lead commentary of Alphorum, our fixed-income quarterly, we examine the forces driving the new paradigm for fixed-income investors and the opportunities emerging.

As central banks (finally) turn hawkish, a new era begins

Action is clearly necessary, but the US and European central banks’ poorly signalled shift from market support to aggressive inflation-control is a change of paradigm which has caused whiplash in fixed-income markets and exacerbated uncertainty. As if to underline the point, when the latest US consumer price index inflation print came in at 9.1%%, the market priced in a one-in-three chance of an unprecedented 100bps Fed rate rise later in July. While the issue is real, our view is that reactions to inflation concerns sometimes overshoot, offering intriguing opportunities for fixed-income investors focused on the longer term.  

Faced with a combination of rising prices and slowing growth, both the Federal Reserve (Fed) and European Central Bank (ECB) behaved more like capricious lovers than paternalistic figures towards markets for much of Q2. However, with both having finally discovered their inner hawks, the emergent macro and market dynamics represent a new world for fixed income.

The threat of long-term inflation expectations becoming unanchored seems to have been the trigger for the Fed to go back on Chair Powell’s word and impose a hefty 0.75% hike in June, in what appears to be intended as a short, sharp shock. The situation for the ECB is more complex, with fragmentation risk between the sovereign bond yields of Eurozone members potentially affecting the bank’s ability to raise rates. Despite this, the ECB hiked rates 50% in in July – its first increase since 2011 and largest since 2000 – and signalling a potential further increase in September. (It is worth recalling that barely six months ago the bank predicted no rate hikes in 2022.)

The late and incoherent nature of both banks’ intervention invites legitimate concerns about credibility, confuses expectations and heightens volatility in the short term. However, ultimately both central banks had little choice but to tighten. With inflation control – not market support – now the firm priority, it is no exaggeration to describe this as a new era for markets.

Inflation control, at what price?

Economists tend to prefer thinking in neat, smooth lines from A to B. However, given the unprecedented level of stimulus pumped into markets for more than a decade, the reality is likely to be a much bumpier and less direct route forwards. The Fed has made clear it intends to be aggressive with hikes in the short term and will go above the neutral real rate – its long-term forecast is for 2.5%, but dot plots for the coming months see it rising to about 4%. Meanwhile, the ECB has left the door open for whatever rate increases are necessary. Like former ECB President Mario Draghi’s pledge to save the euro, the bank might do “whatever it takes” to contain inflation.

Aside from the impact of monetary tightening, we believe easing supply-side constraints and soft demand drivers will also have a moderating effect on inflation in the coming months:

• Housing market conditions: US mortgage rates have escalated, which should create a significant drag on demand. House prices are structurally high but should come down; house sale volumes, which usually lead house prices, are declining
• Covid-related issues: supply-chain bottlenecks should ease, although China’s zero-tolerance Covid policy continues to be a risk and the Ba.5 variant could result in further lockdowns. Short-term fluctuations may therefore still be present.
• Consumer confidence: Indiscriminate Covid-related stimulus for consumers, which has been a factor in demand-side inflation, has ended. Meanwhile, wage increases cannot keep pace with inflation, reducing excess disposable income.

So, while the US economy may appear to have a fire in its belly, when combined with these factors a 4% interest rate would likely have a meaningful impact. Meanwhile, in the Eurozone, with the economic recovery incomplete, output gaps still negative and wage pressures much weaker, the economy is notably less overheated and thus more vulnerable – even if subject to smaller rate rises. That makes recession a real possibility for both.

While nobody doubts the need to bring inflation under control, the question is: how much action is actually needed and at what price? Our view is that inflation is likely to be peaking, or at least close to it. At the same time, we have flagged previously our belief that central banks may be too optimistic on growth, and our view is that current expectations are exaggerated.

Towards a ‘new’ paradigm

For years, the problem of how to end more than a decade of interventionism and accommodative monetary policy has been a thorny question on the minds of economists and central bankers. With structural inflation around the targeted 2% mark finally looking possible, the path has been cleared for central banks to start unwinding some of the policies employed in the wake of the global financial crisis.

However, the problem in this new world is that despite continuing talk of inflation targets and neutral real rates, nobody knows exactly where normality lies. How quickly and decisively support can be unwound, and inflation moderated, depends on managing and adapting to a complex web of factors. Those mentioned above are transitory, but others are more structural and longer term:

• Onshoring: ongoing issues are driving developed-market businesses to shorten their supply chains, reducing risk but increasing costs.
• The green revolution: substantial investment in the energy transition will increase demand for renewable-energy capacity and infrastructure, with policymakers active in driving the change. The ECB’s greening of its corporate bond holdings is notable in this regard, which is the focus of the sustainability section of this issue of Alphorum.
• Energy prices: with demand growing as decarbonisation climbs the policy, corporate and social agendas, prices are unlikely to drop back down significantly in the near future.
• Demographic shift: the global workforce is starting to shrink, just as an ageing society requires new labour-intensive services. The resulting competition for skilled workers will drive wage inflation.

So, although we see inflation decreasing from current highs in the near term as short-term shocks subside, these underlying factors will lead to ongoing structural inflation at a higher level than has been seen over the past decade. In the meantime, it is likely that markets are in for a bumpy ride.

A once-in-a-generation opportunity for long-term investors?

For now, market uncertainty about both inflation and growth are resulting in weak liquidity and extreme volatility in yield levels for fixed income, with double-digit, intra-day basis-point moves for developed-market rates seen on more than a few occasions recently.

In our view, the rare dislocation between high short-term inflation and low longer-term growth has provided a once-in-a-generation window of opportunity for bond investors with medium-to-long-term time horizons. Essentially, markets have overshot in repricing the new environment due to uncertainty about when rates will peak and the ‘front loading’ of hikes into prices. As a result, yields for high-quality corporate bonds are at almost unprecedented levels. In particular, entry points for investment-grade corporate credit and crossover bonds (rated BBB to BB) are at compelling levels. These dislocations are unlikely to endure as the market adjusts to the new reality, so in our opinion, savvy long-term investors should take advantage of the buying opportunity.

Rising hopes for more fallen angels

As market tightening and heightened spreads persist, one result is likely to be a positive net supply of fallen angels: issuers downgraded from investment-grade to high-yield status. Our analysis of past evidence indicates this should lead to a period of outperformance for fallen angels as an asset class. Given attractive current valuations and strong achievable yields, that would represent another forward-looking opportunity for fixed income investors. We explore this topic further in our systematic research section.

Portfolio implications

While it is difficult to be truly bullish in such a volatile environment, we believe the worst is probably in the rearview mirror for fixed-income markets. With this is mind, we have begun to make changes to our Global Fixed Income Opportunities Strategy:

• Managing duration: we maintain an overall short-duration bias, but higher yields have enabled us to increase duration somewhat, making us less underweight than in past months.
• Reduced exposure to high yield: with the primary market effectively closed to most high-yield issuers since the start of the war in Ukraine, shaky candidates at the lower end of the risk spectrum are starting to struggle. We have therefore reduced our exposure to lower-rated high yield and emerging-market bonds, while focusing our interest at the top end of high yield (BB and BB+), where we expect increased fallen angels supply.
• Leaning into investment grade: at the same time, attractive valuations are making it profitable to focus on the investment-grade market. Consequently, we have increased our exposure to this sector more than we reduced our holdings in high yield, to keep credit risks balanced.

As always, adaptability will be the key to exploiting market shifts and dislocations, and we remain ready to make further changes as threats and opportunities arise.

To read the full Q3 issue of Alphorum, please use the download button provided.

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