Shocked, not awed: adapting to the new fixed-income outlook

To open the Q2 2022 issue of Alphorum, where we provide alpha-seeking perspectives on global fixed income, our lead commentary assesses the changing outlook – from central banks’ fight against inflation, to analyses of potential outcomes from the Russia-Ukraine war and the market impacts of oil shocks, and the return of spread volatility. 

Stay tuned in the coming week, as we provide insights into the dynamics driving developed and emerging market bonds, corporate credit, sustainable fixed income and research findings from our systematics team.

Security in unsecurity

In his 2003 book, “A Mathematician Plays the Stock Market,” Temple University Professor John Allen Paulos refers to a lesson learned from his father: “Uncertainty is the only certainty there is, and knowing how to live with insecurity is the only security.” This has probably always been true, but it seems truer than ever in 2022.

Regular readers of Alphorum will by now have noticed that agility, flexibility and adaptability in the face of uncertainty are recurring themes. We make no apologies for this, given that events have a habit of repeatedly bearing out the validity of this philosophy. The war in Ukraine, which most Western geopolitical experts believed was not going to happen right up until it did, is the latest example.

Nobody can have failed to have been affected by the news and images coming out of Ukraine since late February. However, from a market perspective at least, those of us who are veterans of a few campaigns know that war-related shocks are usually short and sharp, with high yield fixed income in particular tending to rebound quite strongly.

That being the case, usually people want to buy the dip. However, this time it’s clear that the world has changed. At this point, even if the war were to end quickly, the implications of the fallout from the conflict are profound and have no simple solution. That makes the situation less clear cut and harder to negotiate effectively, for central bankers and investors alike.

Central banks set their sights on cooling inflation

For central banks, the implications of the war for the global economy are a distraction from the important task of trying to catch up with inflation, which nearly everyone, including the Federal Reserve (Fed), now accepts is no longer transitory. As we entered 2022, despite persistent inflationary pressures and ongoing supply-chain issues, the global economy essentially felt strong. However, with the conflict both driving up commodity prices and exacerbating supply-chain problems, a stagflationary impulse is increasingly evident.

While oil and gas prices dominated the headlines, the cost of metals including palladium and nickel – used for producing semiconductors, lithium-ion batteries and other technology vital to the energy transition – surged. Foodstuffs including wheat and sunflower oil, of which Ukraine is a major global supplier, also got scarcer, with knock-on effects for suitable alternatives like rapeseed oil. Meanwhile, reduced supplies of fertiliser from Russia and Belarus have compounded existing issues including a China export ban and the impact of a Canadian rail strike. Scarcity inevitably means higher prices, creating the potential for an inflationary spiral which central banks must be seen to be addressing. Having said that, they will need to be flexible and ready to soften tightening somewhat depending on how the situation develops.

Conflicting scenarios

Given the interplay of conflicting factors, we see a range of possible outcomes going forward. A neutral scenario would be that the Russia-Ukraine conflict continues, but remains contained and there is no further major economic disruption on a global scale. This would underline the stagflationary impulse, with commodity prices feeding into rising inflation while growth slows down in the medium term. Fiscal push from policymakers, including spending on defence and energy subsidies, would support growth, while monetary tightening would continue as central banks look through the supply-side shock, while remaining vigilant and ready to become marginally more dovish depending on market reaction. 

A more pessimistic scenario would see a serious escalation of the conflict from both sides, both militarily and politically. Sanctions would be increased and include much tighter control on Russian oil and gas exports. With no significant diplomatic or military progress, as time wore on the risk of a recession would increase. The risk-off mood would become more entrenched, with repercussions and some broader contagion across asset-classes, countries and sectors. In Europe, the European Central Bank would be forced to put monetary policy on hold as downside risk from stalling growth begins to dominate, and a sizeable fiscal response could be expected.

Finally, taking a more optimistic view there could be some de-escalation of the conflict. Pragmatism and diplomatic progress would return and tail-risks would decrease, although the situation would remain tense and an amount of lasting damage would already have been done, in our opinion. Base effects would quickly reverse high inflation readings so that monetary policy could be refocused on the underlying state of the economy, limiting the downside for growth.

Spreads return

One notable consequence of the geopolitical and monetary-policy situation within the fixed-income universe is that, following the shock-induced market correction, spreads have returned. Assuming what happens most closely resembles the first scenario outlined above and the situation reaches some sort of equilibrium, options to add risk may arise — especially given that many corporates have strong fundamentals and decent cash buffers in place. Volatility is high relative to most of the last decade (although only half that of March 2020) and the situation needs to settle. However, if you can live with some higher volatility, spread products are offering interesting returns (although given that we are in a maturing cycle it may make sense to avoid being too long on cyclicals at this point). As always, the key will be to invest in companies with future-proof, resilient, sustainable business models who are on the right side of the significant changes wrought by the conflict.

FIG 1. Volatility returns

Source: LOIM as at March 2022.

Learning from past oil shocks

While the past is never a perfect predictor of the future, there is always value in learning from history to help us understand what could happen. Our Systematic Research team recently completed a piece of analysis focusing on three past oil shocks and their impact on credit spreads: the Yom Kippur War and Arab Oil Embargo of 1973-74, the Iran Hostage Crisis of 1979-80, and the First Gulf War in 1990. Their key conclusion is that past episodes have not in themselves led directly to solvency crises and have generally been manageable for credit. What’s more, the global economy is far less oil intensive than it was in the past, so the impact of higher oil prices should be less significant this time around (although surges in the prices of gas, battery metals and other commodities may partially counteract this). In fact, the current situation is arguably more comparable to the post-war commodity shock of 1946-1949, where an inflation spike passed through negative real yields, keeping nominal yields more stable.

FIG 2. Impacts of past commodity shocks

Source: LOIM as at March 2022.

A threat to earnings but not to solvency

Amid the considerable uncertainty, it’s important to remember that the recent crisis has been an earnings shock rather than a solvency shock. With that in mind, the implications should be far less severe than something like the global financial crisis, at least as far as fixed income is concerned. Current expectations of 2.5% terminal Fed rates will be manageable in terms of debt servicing costs; these would only reach maximums seen in the Volcker years of the 1980s at a yield of 4.5% for US 10-year debt. Having said this, the situation differs from past episodes in that historically high debt-to-GDP levels make the system more sensitive to rate moves. That gives monetary policy more political weight but limits the headroom available to the Fed, which will therefore want to act quickly and decisively to tame inflation. Whether it proves successful will be significant in deciding where the path leads next.

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