We expect economic growth around the world to slow this year. That’s a relatively consensus view today, but it’s something we have been calling for some time and, importantly, we believe the depth of the slowdown ahead of us is not currently priced into bond markets. While macro data remains fairly strong, with decent headline GDP in many areas of the world and resilient job markets, many leading indicators suggest this may not last.

In 2022, there was an extreme amount of monetary tightening. As this tightening feeds through economies over the next 12 to 18 months, growth should soften further. Indeed, PMIs are already pointing south in many regions of the world. Interestingly, the new orders component of the PMIs is showing this in an even more pronounced way.

Furthermore, confidence from CEOs, which can drive investment and hiring intentions, is at very depressed levels. Consumers are facing tough times in many countries with negative real growth for wages, increasing credit card debt and pretty depressed sentiment. Consumption, which is roughly 70% of GDP in the US, should therefore be watched closely as the year unfolds. Tighter financial conditions are driving down activity in housing markets, with prices decreasing across most regions in a meaningful manner.
Inflation is receding – will rates follow?
Meanwhile, inflation, the bane of the bond investor, looks to be moderating based on recent data reports. Cost-push inflation is receding, with China and US PPI trending down on a year-on-year basis, improving supply chain pressures and shipping rates collapsing. Commodity inflation is slowing down, with many segments of the commodity market showing lower or even negative growth. Shelter, which constitutes roughly one-third of US CPI, can also be expected to slow down as house prices decrease. If we look at more timely indicators of rental inflation such as live market rental prices, we see negative growth on a month-on-month basis.

Should cost-push inflation fall back as expected and commodity prices ease, central banks will change their stance with regards to monetary policy. We still see rate cuts in the second half of 2023 as a solid possibility from the US Federal Reserve, and in that scenario government bond yields should keep receding. Additionally, financial stability risks or rising unemployment can bring forward a pivot in central bank policy.

Falling house prices, the third point of our inflation outlook, leads us to take a very constructive view on government bonds particularly in the United States, Australia, New Zealand and South Korea, where we expect much lower government bond yields going forward, with the potential for compelling total returns.
Pockets of opportunity
While our overall outlook sees lower growth/recession in many areas of the globe we find some attractive pockets of opportunity in credit markets, both in developed market investment grade and high yield bonds. Within high yield, in particular, we see good overall return prospects for senior secured bonds in defensive sectors such as telecommunications, healthcare and consumer staples. Recent volatility has in our view created interesting opportunities across bank capital securities, while we also see some more idiosyncratic opportunities within the gaming and cruise lines sectors.

While we have high conviction that central bank policy will change as growth slows, and better times lie ahead for bond investors, the timing will always be uncertain. In the past, however, yields have moved a long way quickly when central banks pivot on policy. Fortunately, given the rise in yields we saw last year investors are now being ‘paid to wait’ with a much more attractive income return than has been available for many years.
Historical perspective
Although we foresee a more positive environment for rates in 2023, the outlook for credit spreads is more uncertain. Indeed there might be some additional widening or volatility in spreads ahead, especially for high yield, to reflect the weaker macro conditions.

This implies that the classic negative correlation between government bond yields and spreads might reassert itself, rewarding a diversified barbell strategy such as the one we employ in our own strategy. While we think that credit investors are currently being paid to wait, we do believe that government bonds can offer not only the potential for positive returns but also an important hedge to counter volatility in credit.

Our strategy’s asset allocation, when paired with scrupulous credit selection aimed at avoiding default situations or permanent loss of capital, can help to deliver strong risk-adjusted returns, especially during moments of higher volatility for credit markets.

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