RATES
Inflation may have peaked and could be set to fall, primarily due to the underlying price components that have either peaked or are coming off their peak. However, the big question remains whether wage inflation will continue to drive second round effects and keep inflation stubbornly high, above central bank targets. In the US, another factor to consider is whether the high cost of shelter will normalise. Central banks have a more direct impact on wage dynamics, but we need to be aware of the long lags between policy and its impact on labour and wages. The key challenge for central banks is to tighten policy enough to avoid a cost-wage inflation spiral, without overdoing it. Our base case scenario assumes a tightening process similar to what is currently priced in, but we need to be aware that not all central banks have the same mandate, and not all CPI baskets are created equal. This means that some central banks will be more dovish than others. As a result, it’s time to close any remaining underweight duration, and add to markets where one expects central banks to be more advanced, or where more than sufficient tightening is priced in. The key risk is that central banks stop too early, or that the tightening currently priced in isn’t enough. This could lead to stubbornly high inflation and additional central bank tightening.
A key question is to what level inflation will converge after the normalisation from the current high inflation prints has faded. It would be wrong to assume it will naturally converge to 2% on the back on monetary policy. We have a number of reasons to believe that inflation could end up structurally higher, compared to the low inflation regime just before COVID, with the ECB struggling to bring inflation to its 2% target. A number of underlying factors (including the continued reversal of globalisation, the shrinking labour market, the impact of climate change on business models and costs and the impact of the energy transition on the demand for skills and commodities) are only a few reasons to believe there will be more upside pressure to inflation.
Meanwhile, the slow-moving nature of ‘shelter’ in the US CPI means it often lags behind underlying rental and housing market dynamics. Given the weakening trend of many housing indicators, we expect shelter costs to gradually come down, but lags could be long. This difference in composition could create significant differences between US and European inflation, as US inflation may be somewhat less volatile.
Overall, inflation expectations are currently priced reasonably (similar to 2017 and 2018). As a result, inflation-linked bonds still provide a hedge against future upside inflation surprises.
CREDIT
When it comes to credit, the key message we want to bring forward is the attractive valuations across the board, whether you’re looking at investment grade, high yield or convertibles. Credit spreads have become very attractive, even with the threat of a recession looming. And while we’re taking a more cautious approach to high yield, we’re overweight in investment grade and neutral on convertibles. In particular, we’re seeing some great opportunities in European credit spreads, and favouring pure treasury exposure in the US.
EMERGING MARKETS
Emerging markets (EM) look particularly promising right now, thanks to a number of factors. For one, the global growth slowdown and easing inflation in many countries is a positive for duration. Plus, with greater clarity on the Fed’s stance and a slower pace of tightening, we’re expecting to see reduced volatility in the markets. Valuations are also looking attractive, particularly compared to historical levels, and comfortable carry is providing a useful buffer for total returns. And with low positioning already in these markets, there’s plenty of room for growth.
Of course, it’s not all good news. There are some negatives to consider, such as the tight monetary conditions in developed markets and their potential impact on appetite for emerging markets investments (especially as fiscal policies remain loose). The fact that we are coming closer to ‘peak tightness’ has historically been a positive trigger for EM bonds. Overall, we are positive on the outlook for EM local debt and believe that EM markets holds the potential to be a worthwhile investment focus in 2023.
