This has been a difficult year in which to be a fixed income investor, with a ‘double whammy’ of interest rates going up, as worries about inflation rise, and credit spreads selling off due to tighter liquidity and poor economic news. When interest rates and credit spreads are both underperforming that doesn’t leave many places for a bond investor to shelter – for example, both sterling investment grade and global high yield markets have double-digit losses so far this year.
The drivers of this turmoil are well documented: the Russia/Ukraine war, Federal Reserve raising rates, and Chinese economic problems exacerbated by new Covid lockdowns. But if a few years ago I would have described to you a world in which China was rolling over, where growth in most markets was slowing down, where there had been an enormous amount of wealth destruction as crypto/tech stocks cratered, and the global property market looked weak … what would you have guessed central banks would be doing? It would have taken a brave and contrarian character to predict that policymakers would be tightening in those circumstances! And yet here we are.
In many ways it feels like central bank, with their total focus on inflation, is ‘fighting the previous war’ rather than looking at the situation we’re currently in. As bond investors we’re trying to get our heads around that. On a medium-term basis, credit looks quite attractive to us but we are aware that volatility will persist over the short-term.
Much of that short-term volatility in sentiment has been driven by the painful spike in energy prices, which not only drives inflation, but contributes to lower economic growth as squeezed consumers have less to spend on discretionary goods and services. But my view is that in 6-12 months’ time we won’t be talking about energy prices nearly so much. Yes, as Russia cuts off its supply of gas to Europe that sets up a very challenging winter, in which consumers, businesses and politicians will have tough time of it. Markets, however, are a self-correcting mechanism as the supply/demand balance shifts in response to such events.
What I expect will happen with energy is that politicians will step in to help the most vulnerable, while the high prices will reduce demand. In the UK in August, power demand was down 10% year-on-year largely, I suspect, because consumers and businesses were making rational decisions about reducing their consumption in the face of higher prices. We’ve seen countless times that, when trouble is on the horizon, markets panic ahead of the event and then – when it eventually comes – markets realise the reality isn’t as bad as first feared, which then leads to a rebound.
For bond investors like us, one of the most relevant questions regarding energy prices is: what will high energy prices this winter mean in terms of inflation and interest rates? If you believe that sky-high energy prices are here to stay then I’d suggest you should be expecting inflation to fall next year, not least due to the deflationary impact of the enormous damage that would be done to the European economy.
Has inflation perhaps already peaked? Well, I wouldn’t go quite that far, but the last time I remember reading a bullish short or medium term outlook for the global economy was in the initial post-lockdown sugar rush of economic reopening. Furthermore, last year there was a lot of talk about how the copper price would push to ever-higher levels as the ‘green revolution’ stimulated demand, yet the copper price is down substantially this year. Freight rates are also down a lot, as there is so much less demand to move goods around the world. On a personal level, do you feel richer or poorer than you did a year ago? If you say ‘richer’ then congratulations to you, but I bet you’re in the minority!
Everything is screaming recession. Recession exerts an extremely powerful downward pull on inflation, and although it wouldn’t surprise me if inflation kept climbing for a few months yet, as bond investors we’re buying assets based partly on a view of what average inflation might be over, for example, 10 years. Over that kind of time period, and if investors do their due diligence carefully in order to avoid defaults, I think there’s reason to be optimistic on fixed income’s return potential.
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