After the widespread disruption caused by last year’s sharp increase in interest rates, the markets expected some respite this year. They assumed a straightforward script: high interest rates to suppress elevated inflation would cause a severe recession prompting central banks to relent on their hiking path. However, the story line hasn’t followed a familiar fairytale route and has seen many twists and turns.

Growth has remained resilient, and inflation has proved to be sticky, surprising central banks as well as the markets. The turmoil in the US regional banks raised financial stability concerns and briefly raised hopes of a halt in rate hikes earlier this year. However, banking woes seem to have subsided for now and major central banks, including the Federal Reserve have vowed to raise rates further to win the inflation battle.

The year saw central banks and markets becoming heavily dependent on every new piece of information for making the next move. The plot moved between “hard landing,” “soft landing,” and “no landing”. In this scenario, markets have behaved in an erratic manner, with both bonds and currencies moving in a wide range. The lack of directionality in the markets made portfolio management a highly complex exercise, with multiple investment themes emerging on a weekly and sometimes daily basis.

The first half ended with yields still rising, curves flattening and the US dollar gaining against cyclical currencies. This is the type of price action one sees at the end of the cycle. Talk of a deep recession is now in the air.

Debt levels have fallen

But this could be a red herring and we do not anticipate such a scenario as the current situation is way different from the high debt levels seen after the Global Financial Crisis. Consumers as well as corporates are now deleveraged.

On the fiscal side, it seems as if governments have forgotten the word ‘austerity.’ For instance, a textbook reaction to tackle inflation in the UK would have been to increase taxes. That would have an across-the-board effect on demand and back the Bank of England’s fight in taming inflation. However, policy makers are coy about even uttering ‘austerity’, particularly ahead of next year’s election. Public sector wage increases announced by Prime Minister Rishi Sunak could add to inflationary pressure.

The labour market continues to be tight, with low unemployment levels and a rise in wages, which is further fuelling demand and inflation. There is an argument that the ageing demographics could be deflationary but a counter point to that could be that a shrinking workforce could be inflationary as well.

Geopolitical headwinds

Stronger structural demand from geopolitical changes will also spur more broadbased spending. Nations are increasingly building capacities within their borders following the supply chain debacle caused due to reliance on China during the pandemic. Higher investments related to the green transition as well as a boost to defence expenditure amid the Russia-Ukraine conflict may also underpin demand.

Inflation has declined at a glacially slow pace over the year, with the manufacturing sector suffering as demand shifted to services after covid lockdowns ended. This has left manufacturers holding expensive inventory, which they’ll try to offload over the next three to four months in an attempt to bring back demand from services.

We expect the Fed to pause in the coming months, which could be followed by some rate cuts. Such a scenario will reduce volatility, steepen the curve, and improve the environment for investments in bonds. However, we don’t expect any aggressive cuts as the foundation of growth continues to be solid.

Flexibility is key

We also believe developed market central banks won’t revert to the low interest rate regime witnessed over the past decade as inflation may continue to hover above targets for much longer.

In contrast, we see value in emerging markets, in both hard and local currency bonds. Emerging markets are now ready to reap the benefits of hiking rates at the right time in 2021, when their counterparts in the developed world were taking it easy. We particularly like bonds in Brazil, Mexico and South Africa.

Managing fixed income assets in an unpredictable macro environment calls for a lot of flexibility. While the flavour of a season could drive investors towards one fixed income strategy or the other, absolute return strategies are designed to work in all environments. Our approach is to focus on predicting the macro call correctly, which forms the basis for the direction in which interest rates are headed. We believe, if we get that call right, the plot will sort itself out, and help us generate alpha.

The value of active minds: independent thinking

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