In the beginning of the year, there was optimism that demand for goods and services will increase as the adverse effects of Covid ebbed. Investors’ belief in the reflation story faded as soon as it began as Russia’s invasion of Ukraine pushed up food and energy prices and raised concerns about rampant inflation. That soon led to worries about recession as inflation typically erodes purchasing power. Bond yields surged at the end of summer as governments that wanted to cushion the impact of high energy prices unwittingly ended up stimulating the economy while central banks battled to contain inflation on another front.
Given the turbulence this year, it’s important to assess the prospects for fixed income in the coming months. To be sure, there has been some improvement in four of the five problem areas that have worried the financial markets in 2022. Central banks have tightened aggressively to contain spiralling inflation and that’s reflected in market pricing, energy prices have softened, governments have recognised their folly in pumping in more cash during a period of high inflation and China seems to be easing its stringent Covid containment policies. The tight labour market, however, is still proving to be a quandary for policy makers.
Already, the US Consumer Price Index provides some evidence of deceleration in inflation. Supply chains, which constricted many sectors during the pandemic, are improving and the rise of the dollar has helped to keep import prices down in the world’s largest economy.
In the longer run, the events of the recent months is a wake-up call for Western economies. The geopolitical uncertainty triggered by Russia’s invasion and tensions between the US and China as well as the disruption caused to supply chains during Covid will force the West to focus on manufacturing once again and also the security of its supply chains in the longer run.
This tug-of-war between growth an inflation means the environment will remain fluid. Therefore, we expect interest rates to stay higher for longer, limiting any rally in bonds in the US and other developed markets, with the US dollar weakening from elevated levels. In this scenario, we see a lot of value in emerging market currencies of resource-rich countries such as Brazil, South Africa and Mexico as well as their local currency debt. We also like contingent convertible bonds and debt issued by peripheral European nations such as Italy and Greece.
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