As countries around the world continue their efforts to quell the post-pandemic inflationary spike, central banks are reaching the end of their tightening cycles on different schedules and with different peak policy rates in sight.
Against this backdrop, bond yields have spiked, but they offer resilience amid increasing risks to the global economy which, led by the U.S., has shown remarkable endurance during this period, despite one of the most rapid tightening cycles in modern history. This may have raised questions about the effectiveness of monetary policy but we believe it is still working, albeit mostly with lags.
We believe growth has peaked and resilience will turn into weakness as growth slows later this year and into 2024, while fiscal headwinds – especially in the U.S. – will soon come into play. We believe inflation has peaked as well and forecast core inflation in the 2.5%–3% area in the U.S. and Europe at the end of 2024.
Hard or soft landing?
But a soft landing from here would be an anomaly, as it’s historically rare for central banks to achieve a soft landing – or avoid a recession – when inflation is high at the start of a cycle, and when central banks hiked policy rates by 400 basis points (bps) or more – as several have done this cycle.
While healthy starting conditions for household and corporate balance sheets, as well as proactive financial stability policies (think of the BOE’s intervention in the LDI crisis) have so far successfully thwarted a recession, history suggests that tight financial conditions create a high risk of financial market accidents, and there are areas of vulnerability within markets, such as in private credit, commercial real estate, and bank loans.
There are also risks related to China, where the country’s recovery has been weaker than expected, weighed down by the property market and more stimulus is likely needed to stabilize its property sector and the economy more broadly.
Recession risk
As such, we believe recession risk appears to be higher than markets are pricing. Markets, and risk assets in particular, appear to be priced for an “immaculate disinflation” scenario, in which growth remains solid and core inflation drifts toward central bank targets fairly swiftly. We think such pricing may reflect complacency.
We see growth in DM economies falling to varying degrees in coming quarters, with the most interest rate sensitive faring the worst. Europe and the U.K. also look vulnerable due to trade links with China and the lingering effects of the energy shock to terms of trade and investment. U.S. growth also looks set to slow, hovering between stagnation and mild recession.
This collective slowdown may also play out differently across countries depending on their sensitivity to changing interest rates. Structural differences in housing markets and mortgage financing will play a role. We arrived at five key economic themes and three investment themes for our 6- to 12-month cyclical horizon, which we discuss in the next sections.
Investment implications
Our baseline scenario sees inflation continuing to decline toward central bank targets, even as wage pressures take longer to cool, but we remain vigilant about building portfolios to mitigate against both upside and downside surprises.
All that said, the outlook for fixed income looks compelling. After their recent rise, starting yield levels, which are historically strongly correlated with returns, are extremely attractive, with both real and nominal yields at levels not seen for a decade or more.
High-quality bond funds today yield about 5%–8%. This looks very attractive versus expected equity returns and offers downside protection in the event of recession. At today’s elevated yields, bonds look attractive even if inflation were only to decline toward the upper end of our forecasts, and these yields can provide investors with much more cushion against uncertainty.
We maintain a cautious stance on corporate credit, given recession risks, and an up-in-quality bias across the board, and remain concerned about lower-quality, floating-rate corporate credit assets, such as bank loans and some legacy private credit assets, where we are already beginning to see strain from higher rates.
We also expect bonds and equities to resume their more typical inverse correlation – in which bonds perform well when equities struggle, and vice versa – as inflation returns closer to central bank targets over the next year.
Our assessment is that the neutral rate will return to pre-pandemic levels, which would tend to anchor fixed income returns and, combined with higher term premiums, over time should lead to re-steepening of yield curves.
But while global fixed income yields are very attractive today, we expect greater differentiation in terms of returns from high-quality fixed income investments across countries and, as a result, emphasize the global opportunity set and diversified sources of bond risk and return.
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