Jim Leaviss, CIO of M&G’s Public Fixed Income provides his outlook for the second half of the year. He highlights 5 key points:
What is your outlook for inflation and global growth in the second half of the year?
The first half of the year was all about inflation, but as we move into the second half of the year bond markets are starting to rotate their fears towards a possible recession. We saw a big sell-off across fixed income markets in H1, with 10-year Treasury yields getting as high as 3.5%. However, over the past couple of weeks markets have become more focused on recession risks, amid a sharp fall in US consumer confidence. Bond markets are now starting to look through the cycle, pricing in the possibility that central banks may have to start cutting rates in 2023 as recession fears grow.
Europe probably faces the greater risk in this respect, given the uncertainties over gas supply which could have a significant impact on German growth in particular. However, given the near double-digit levels of inflation in Europe, we think the ECB will for the time being need to keep hiking in order to maintain their credibility – they have to be seen to be acting. What’s not clear at this stage, is what level inflation will need to fall to before they are prepared to start to loosening policy again. In the meantime we may see other actions to boost European growth, such as renewed fiscal stimulus.
In the UK, we are seeing very elevated inflation, combined with cooling growth. Notably, the Bank of England appears somewhat more dovish than its peers, including even than the ECB. Given this dovish tilt, it feels like inflation in the UK could remain high for longer compared to other regions. At this stage it’s unclear what damage inflation could do to the economy so it is important to monitor the situation closely.
Where do you expect US inflation to be by the end of the year?
There remains a lot of uncertainty, but at this point I would expect US inflation to gradually fall in the second half of the year as slowing growth starts to dampen price pressures. By next year I think US inflation is likely to go below 4% as significant base effects start to kick-in. Looking beyond that, I think central banks may have a more difficult job keeping inflation below 2%, as many of the forces that kept inflation low for many years start to unwind. In particular, globalisation is likely to be a less powerful force going froward, given issues such as Brexit and the increasing incidence of trade wars.
What are your thoughts on credit and are you starting to find opportunities after this year’s sell-off?
Yes we are starting to find some interesting opportunities in credit. The sell-off this year impacted all areas of the market, across both investment grade and high yield, and was very much driven by the Fed’s hawkish pivot. Investment grade corporate bond yields are at higher levels than during the height of the Covid crisis. The key difference this time, is that the spike in yields has been driven by a higher risk-free rate, while credit spreads have been relatively well-behaved.
At the moment credit markets appear to be pricing in a downturn, but not an outright recession. Therefore, while we think now is a good time to be selectively adding risk, we are focusing on higher quality, more defensive names which should hold up better if we do see a more recessionary scenario. We would highlight areas such as US utilities, waste management businesses and railroad companies that should offer resilience in a slowing economic backdrop.
The other good news is that we expect defaults to remain low in most parts of the market, with many companies having taken the opportunity to re-finance their debt for several years. Overall, we think investors are being well-compensated for taking credit risk. However, there are some areas where we remain wary, such as CCC-rated high yield names where we think defaults could rise quite significantly. There are also a number of sectors which we think could face stress, notably retailers and European property companies.
Turning to currencies, can we expect further USD strength or has it peaked?
The USD was the standout performer of H1 2022, driven by its safe haven attributes and attractive interest rate differentials versus other countries, such as the eurozone and Japan. If the Fed is able to engineer a soft-landing, then we think the USD is likely to weaken from this point. However, if we see a hard-landing and a sharper economic slowdown, then we will probably see further USD strengthening. At the other end of the scale, the JPY has been a very poor performer over the past couple of years. Again, a key driver has been interest rate differential, with the Bank of Japan keeping interest rates pinned to zero.
What is likely to keep you awake at night in the second half of the year?
For me, there are two things. Firstly, the risk of further energy price rises over the winter months and what this could mean for both consumers and industry. There is already talk of a possible 4-day week in Germany, while in the UK it has been suggested bills could rise from £800 to £3000. Longer term, I continue to be worried about threats to democracy – the increasing incidence of leaders who appear unwilling to follow international laws or reluctant to leave office poses a serious and growing concern for stability.