Bonds have rebounded sharply this year after a torrid 2022, encouraged by improving picture on the inflation front. Many questions abound in investors’ mind now: what is the outlook for growth? Is recession still a possibility? Have major central banks decisively conquered the inflation problem or how soon will they pause or cut? And can the bond rally continue unabated and which segments and geographies look attractive?
A mix of factors, including Covid-19 and Russia’s invasion of Ukraine, had pushed inflation to multi-decade highs last year. But those distortions have now receded. Goods prices are falling, and services ex-shelter is also looking better, while energy prices have also dropped. Rents are declining and that should help soften shelter data too. In the US, Consumer Price Index (CPI) based inflation has declined for three straight months. We are also starting to see some relief in wage data.
Weak growth has underpinned the bond rally. But the foundation for growth is still good as consumers are delevered, banks are in a good shape to lend, there is no sign of any financial crisis, and the job market is more or less intact. It looks like we are headed towards a soft landing. Any recession may turn out to be shallow and we actually expect that growth will start to surprise on the upside. As inflation slows, the growth backdrop will improve as real incomes will increase.
However, we don’t expect growth to be broadbased across the world. After a relatively strong performance last year, the US may show signs of slowdown following aggressive rate increases by the US Federal Reserve (Fed). The boom in the services sector, witnessed after strict Covid restrictions were lifted, is also beginning to fade as consumers are facing a squeeze after spending their excess savings.
On the other hand, the prospect for Europe seems to be brighter, with the decline in energy prices also boosting confidence. We view the improvements in European growth as the beginning of a much more synchronised and balanced global economic upswing. The ending of stringent restrictions in China is also a positive for global growth.
Slower US growth may further weaken the US dollar and force the Fed to ponder over its aggressive policy. A pick-up in growth outside the US also puts emerging markets in a good position.
The pandemic as well as geopolitical tensions have now made corporates aware of the pitfalls of relying too much on overseas supplies to drive their production. In the coming years, we expect many corporates in the western hemisphere to boost domestic spending to ramp up capacities. Rising defence needs as well as the need to protect the environment through green investments means more local spending.
Bond markets are right now pricing for rate cuts, but we haven’t seen any evidence that the US growth is worrying enough to warrant a reduction in policy rates. We expect global growth to be reasonably good, which in turn should feed into the US economy. The International Monetary Fund (IMF) has already revised its output projections slightly upwards this year. Even if the US is not an outperformer, a rate cut may not materialise if the economy is doing reasonably well. The weakness of the dollar may also underpin its growth. In that environment it’s very possible to imagine that we have higher neutral rates as the prevailing levels may not be seen as restrictive.
We are witnessing a big change in trend now. Before Covid, US growth outstripped the rest of the world, which remained sluggish. In a low growth, low inflation environment, everyone wanted to own the US dollar and technology stocks performed well. EM markets suffered from the rise of China manufacturing, weak global growth, cheap commodities and a US dollar that was harder to source after US banking sector changes and the US discovery of shale oil.
Now the opposite is true. In this environment, emerging market bonds, particularly local currency, should do well. The weakness of the dollar will also preclude any need to hedge currency risk. Emerging market central banks also have the room to use their monetary policy to support growth, while in the west the policy may have to remain relatively tight for the time being to keep inflation in check. We believe Europe has now escaped its liquidity trap with massive fiscal spending, well capitalised banks and a tight labour market.
A big structural shift is underway, where the rates markets in developed countries will begin to underperform emerging markets. This is a far cry from the situation that EM market’s faced before Covid where they struggled to finance themselves amid a negative yielding environment.
Slowing inflation should help stabilise the front end of the bond market and reduce volatility. If the global growth picture is perceived as better ten years down the line than now, then the bond yield curve should start to steepen and more inflation risk premium should be priced to reflect the brighter macro future. Staying long duration in this environment may beget yield but that’ll come with higher volatility so beware. We believe the front end of the bond market offers value presently only, although this could change very quickly.
We also see value in emerging markets, a weaker dollar, steeper curves and the long-end of inflation. Global inflation will probably stay reasonably high as growth picks up, which should cap the rally in the nominal bond market.
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