The fixed income markets have navigated many buzzwords since the advent of Covid. Reflation, inflation, transitory, recession and pivot are just some of them. 2022 has been tough for investors as the macro regime changed many times in a dramatic fashion while major central banks embarked on an interest rate increasing spree.

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.
Outlook 2023: Heading towards a soft landing?
Keeping a lid on inflation
Inflation hit multi-decade highs earlier this year. A sustained period of out-of-control inflation would have dented the credibility of central banks, hurt growth and squeezed real incomes. Central banks are examining the tradeoff between growth and inflation and are not prepared to push their economies into recession. We believe that central banks may tolerate higher inflation for longer instead of trying to bring it down to 2% in the near term as overtightening of monetary policy may induce a sharp slowdown in growth. It’s clear that central banks will accept a gradual slowing of inflation as long as it is within control.

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.
Decline in energy prices
Another positive for fixed income markets is the decline in energy prices. Gasoline prices in the US have declined about 18% since the summer and in Europe natural gas prices have fallen, in part helped by milder weather conditions in autumn. Coal prices, which was a fallback plan for many countries, have dropped too. The relief on the energy front will help to soothe the anxiety of governments about inflation to some extent. The setback suffered by Russia on the battlefront is turning out to be favourable in this regard. The Russian overreach has hit a wall and we don’t expect the situation to get any worse.
Fiscal support confounds inflation watchers
While central banks had a clear focus to combat rise in prices, untargeted spending by governments post summer compounded the problems brewing on the inflation front. As bond yields surged, particularly in the UK, that also put the spotlight on the dangers of reckless spending potentially causing financial instability. Signs of fiscal risks underpinned the upward move in US dollar, putting strain on energy importers. A severe cost of living crisis is biting consumers around the world and governments are expected to help cushion the impact. However, governments seem to have learnt a lesson from their experience this year as uncontrolled tightening of financial conditions stemming from unchecked spending can cause more harm than good.
China easing
China’s stringent policy to contain the spread of Covid has for long been an economic disruptor. But their approach seems to be changing, with around 70% of their population getting vaccinated. The nation has started to reduce restrictions on diplomatic travel and are less harsh to airlines that bring Covid cases to their soil. Although the central government still continues to sound tough, local government are taking a softer stance and getting away with it too. The easing of the policy, even if nascent, is an encouraging sign.
Labour conundrum
One keenly watched metric that really hasn’t changed much is the tightness of the labour market, which is still an inflation generator. Sectors such as hotels, restaurants, airlines and recreation-related businesses continue to face a shortage in available workers. However, policy makers can aim to engineer a soft landing -–slower growth, higher unemployment without mass layoffs and steady markets – if the other factors mentioned stay in control, supporting markets. That’s not to say risks don’t exist. For example, a full-fledged reopening of China could cause a rise in energy prices, in turn keeping inflation at higher levels.

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.
Caution warranted but opportunities galore

Given the measures to damp inflation through the year, we expect growth to slow in the coming months. We expect central banks to take a measured approach with an aim to keeping inflation under control, even if it stays at higher levels than the desired level of 2%. Central banks are going to remain very flexible in terms of what they do with monetary policy. Growth impulses are still underpinned by strong consumer balance sheets as they have deleveraged since the Global Financial Crisis and have also ramped up their savings during Covid. Employment levels are still high and if inflation is successfully suppressed, real incomes will rise, potentially spurring demand. Governments too will end up spending on national security, green transition and improving their supply chains.

 

This tug-of-war between growth and 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.

The value of active minds: independent thinking

A key feature of Jupiter’s investment approach is that we eschew the adoption of a house view, instead preferring to allow our specialist fund managers to formulate their own opinions on their asset class. As a result, it should be noted that any views expressed – including on matters relating to environmental, social and governance considerations – are those of the author(s), and may differ from views held by other Jupiter investment professionals.

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