fixed income
Fixed income in 2022: adaptability is imperative
To complete our quarterly assessment of global fixed income, Alphorum, our lead commentary emphasises the need for adaptability as we progress into choppy waters in 2022. Previous reports in this issue considered timely developments in systematics, sustainability, corporate credit, sovereign developed markets and emerging markets.
Need to know
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20/22 vision
As the great Muhammad Ali once said, “the hands can’t hit what the eye can’t see”. If 2021 in fixed income was all about working out how to best benefit from a supportive carry environment, 2022 will be more about reading conflicting market signals, judging the turning points correctly, keeping light on your feet and being ready to act.
Why everything feels possible
The expectation was that as 2021 progressed it would bring clarity regarding at least the general nature of the macroeconomic terrain going forward. However, as the year ended two divergent scenarios were still very much on the table, one resulting in inflation peaking relatively quickly, the other in a more sustained, structural effect. What’s more, while previously people tended to be firmly in one camp or the other, both scenarios, and multiple variations on their themes, now feel equally possible.
Having enjoyed the narcotic effect of a decade of quantitative easing, markets are waking up to an environment where inflation is no longer a sleeping dog. With financial markets closely coupled with the global economy and higher levels of debt heightening sensitivity to interest rates, even small rate rises have the potential to create meaningful impact. As a result, investors are paying much more attention to macro data such as consumer price index prints and employment figures, which they see as the canary in the coalmine for where inflation is headed — and where rates will follow.
At its core, the global upswing in inflation is being driven by ongoing supply chain disruptions, strong post-pandemic demand and upward pressure on wages, as well as the side effects of government stimulus. Yet, at the same time, the more hawkish tone from the Federal Reserve and other central banks is eliciting market concerns about the liquidity impulse waning, should they slam the brakes on economic activity by removing accommodation too decisively.
FIG. 1 Core US CPI decomposition (MoM annualised, 3-month moving average)
Source: Bloomberg, LOIM calculations as at January 2022.
In recent years markets have become hooked on central bank pronouncements. Up until recently, consistent reassurance that ‘we’re going to keep things as they are and everything’s going to be fine’ has been enough. However, having accepted the need to start acting, bankers are having to wrestle with the difficult question of how to communicate effectively with such a sensitive audience and guide the market correctly. Is it best to tiptoe forward, signalling each small step, or is a hawkish message followed by more muted action the way to go? As the Reserve Bank of Australia — and to a lesser extent the Bank of England — has already found, it’s easy to make mistakes which can unsettle the markets.
A tale of two time horizons
One of the difficulties in reading where the markets are headed in 2022 is the need to consider different time horizons. Investor views on how the next quarter is likely to play out are fairly homogenous, with an expectation that inflation will stay high in the short term. The big discrepancy is about the longer-term play — the question is, how quickly will inflation come back down?
This dichotomy has played out in the recent flattening of the US Treasury yield curve, with higher short-term rates as central banks tackle inflation, but lower long-term rates reflecting expectations of a future slowdown. Behind this is the key question: will growth prove persistent? That’s far from easy to answer. Consumers have been spending savings accumulated during the pandemic, but whether this is a behavioural shift rather than a short-term effect remains to be seen. At the same time, companies are largely following a policy of returning cash to investors rather than galvanising future growth through capex.
FIG 2. US Treasury yields: dispersion with greater duration
Source: Bloomberg as at December 2021. For illustrative purposes only.
Keeping on your toes
Given the impossibility of predicting how things will play out, we prefer to leave grand strategies in the drawer and be ready to act tactically. We expect 2022 to see high levels of volatility, so are focused on positioning ourselves well, keeping on our toes and responding dynamically to exploit pockets of value as they arise. Unconstrained strategies, like our Global Fixed Income Opportunities, can come into their own in this environment.
Low carry and high volatility do not signify a happy environment for low-yielding assets such as government bonds, which fail to offer a lot of protection. With index duration having extended over the years, investors are extremely sensitive to rate moves from a market-to-market perspective. Once central banks reduce their asset-buying programmes, will the yield be right, and are investors going to step into the void? At the same time, what will investor appetite be for the high levels of government debt likely to be needed to support massive fiscal spending plans in the US and the EU?
From a fundamental perspective, the credit market generally looks very healthy, with almost no defaults and many companies continuing to enjoy high cash levels. However, these are expected to recede somewhat over time, and as support from central banks is withdrawn, identifying those companies with strong fundamentals will once again become more important. A number of factors will come into play here, including: the level of debt required by firms, how urgently they need to refinance, the strength of their cash levels and whether these are eroded through sensible investment or ill-advised M&A activity. This speaks to the virtues of an active, bottom-up strategy rather than expecting to rely on beta.
Potential turning points
We have already emphasised the importance of reading the market and responding to changes in the environment. What might the turning points be? Well, in contrast to the past couple of years, they may not come in the shape of clearly signposted changes of direction or sudden shocks. Covid is unlikely to have the same impact as previously; with each new wave, market reaction is becoming more muted. In the developed world at least, there is a shift towards expecting the disease to become something we learn to live with, rather than something which continues to cause major disruption.
Instead, these turning points may comprise a series of small inflections which add up to have larger consequences. For example, how will China continue to deal with issues in its real estate sector? Is the Chinese economy slowing down in a manageable way, or could that become cause for concern? Or more positively, will global supply issues disappear and result in an acceleration in growth? So much of the data remains cloudy. We may feel reasonably confident about the final destination, but there will be many twists and turns along the way. It is in remaining tactical and reacting effectively to these nuances that active managers can make a difference. At times it can make sense to act on central banks’ interpretation of the data rather than the data itself; and even to play the market reaction to central bank communications rather than what the policymakers actually say.
At the same time, being involved in the carry trade means we need to monitor risk, and geopolitics are clearly a potential issue. Situations such as the Russia-Ukraine and China-Taiwan tensions are therefore definitely on our radar. Yet upside risks also exist in emerging markets, with much higher real yields that may attract flows at some point if yields remain low elsewhere. It’s worth noting that in contrast to the past, when central banks in emerging economies have tended to be behind the curve, many have already been proactive in raising rates to support domestic currencies.
One thing to be aware of is the somewhat different landscapes in the US and Europe. The Fed has clearly signalled a more hawkish stance in response to strong growth and persistent inflation, which hit a 40-year high of 7% year-on-year in December. Europe’s recovery lags the US somewhat, and euro area annual inflation was lower at 5%. Consequently, the European Central Bank has so far chosen to remain more dovish and accommodative on a relative basis – but the market is expecting policy tightening down the road (see figure 3). If the rest of the global economy fails to catch up with the US, it may eventually be dragged back down, since a lack of competitiveness on trade would slow down its growth, in our opinion.
FIG 3. Market-implied rate-change expectations
Source: Bloomberg, LOIM calculations as at January 2022. For illustrative purposes only.
Sustainability — a safe bet
Finally, one thing we can confidently predict in 2022 is that the sustainability revolution will accelerate. As we highlight later in this issue of Alphorum, while 2021 has seen a lot of talk about net-zero ambitions, 2022 will be the year in which companies increasingly turn stated ambitions into actionable strategies. Sustainability is no longer a fringe interest and is rapidly going mainstream — as yet, this is far from being priced into the market, providing a real opportunity for investors able to distinguish what we define as ice cubes: companies, irrespective of their current carbon footprint, whose credible decarbonisation targets and genuine progress on reducing emissions makes them leaders in managing the transition risk on the road to net zero.
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