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The world remains dominated by the disruptions initiated by the COVID crisis. These include supply-chain disruptions, fluctuations in demand, fiscal and monetary stimulus packages, tight labour markets, inflation pressure. Add to that the additional consequences of the war in Ukraine.
An economic collapse was initially countered by fiscal excess and monetary easing and is now followed by monetary tightening. And we already are debating about the next recession. These large gyrations lead to three important consequences:
First, in is these highly volatile times, when economic parameters are outside their usual range, it remains very difficult to make accurate short-term forecasts, as most economic models are not correctly calibrated. For example, forecasting the GDP or CPI prints become tricky.
Secondly, uncertainty has increased significantly. Economic policy uncertainty and business uncertainty are at elevated levels. This complicates decision-making for economic actions, but also has a negative impact on risky assets.
Finally, these changes have had a fundamental impact on rate markets. Given the exceptionally high inflation, and the central bank’s response, interest rates have repriced significantly. There is no obvious historical template on which to price interest rates. Even a comparison with the eighties has too few parallels. Therefore, the market has no pricing framework and is in a price discovery mode. This leads to larger volatility and sometimes erratic pricing, making short-term predictions very tricky.
That’s why, in our fixed income outlook, we focus instead on the medium-term perspective: to determine in which direction we are heading and to determine when the trends are turning.
In terms of credit outlook, we remain generally cautious, but we favour quality (investment grade) bonds. Here is why: we are concerned about corporate profitability. The CEO confidence indicator, a US survey measuring CEO confidence in the economy 1 year from now, is showing weakness and this has historically been linked to economic downturns and higher spreads in high yield.
Investment grade credit has also experienced significant widening in spread, to the extent that the spread widening over the past year has already been very important, certainly compared to previous spread-widening episodes in the past: From a historical perspective the widening in investment grade has already gone quite far.
This also applies to high yield. However, given our cautious economic outlook and the fact that high yield spreads historically keep widening for longer periods, we remain more cautious on the higher yield bonds. In addition, investment grade credit has the potential support from the ECB, or certainly from the re-investment of maturing bonds held by the ECB.
Convertible bonds are in a similar situation as high yield. Still, as they have suffered more, their cheapness makes them relatively attractive. But we consider it is still too early to re-enter.
These insights from credit also form part of the ingredients that shape our views on interest rates We have already mentioned the weaker outlook for corporates. The consumer is hit by a loss of real spending power due to inflation outpacing nominal wage increases. As a consequence, the consumer is digging up any remaining COVID savings and starting to borrow more. This is typical late-cycle behaviour.
The observations about corporates and consumer lead to questions about the strength of the current cycle. Markets are already pricing in that central banks will start to ease in 2-3 year.
Given the remaining uncertainty on inflation, we want to remain exposed to inflation-linked bonds and keep an overweight in this asset class. The balance of lower growth and high inflation is more complex. However, in balance we remain somewhat underweight duration, as rates have recently priced lower and therefore some slowdown is already priced in.
Emerging market central banks tightened financial conditions well in advance of developed markets, bringing real rate differentials back to pre-covid levels. Hence, carry is back at attractive levels, but we are weary of the weaker credits, as deficit problems caused by the health-crisis, will add stress.