For all of 2022, we have focused on tighter monetary policy, discussing the dilemma faced by central banks (in ‘Czech Mate’) and their subsequent decision to prioritize the war on inflation (in ‘The Inflation Game’). Since March 2022 we have highlighted that recession over the coming quarters is a probability rather than a risk. More recently, the market consensus has moved to that view.
Yet, while some markets are priced for recession, others are not. The historic volatility in fixed income in 2022 has unglued prior relationships, sending many cross-market, yield curve and cross-credit relationships to unusual levels (read: opportunities). Last quarter we laid out our thesis for how we expect fixed income markets to interact in our outlook called ‘Twin Peaks’. There, we called for a turn lower in government bond yields and the resumption of 2022’s overall trend wider in credit spreads. Our view is unchanged.
Since October, most government yields have finally turned lower – and we think some markets have put in a yield peak. Still, markets can be choppy , and there remains a large gap between the leading and lagging indicators of the US economy. We shouldn’t assume a yield peak in every market.
Follow the leaders
The consensus may have joined us in expecting recession, but not all major voices on the debate have, including the US Treasury Secretary and a major US investment bank. Further, those that do expect recession almost universally expect a mild contraction, without convincingly explaining why.
One reason for continued debate is that while leading and some contemporaneous indicators point to recession, such as open economy Purchasing Managers’ Indices (PMIs), housing data, Institute of Supply Management (ISM) New Orders, and even the ISM itself now, the lagging data led by labor markets and inflation do not. As the laggards catch up with the leaders, market prices should shift. This looks to us a matter of time.
While the US labor market has not yet rolled over, it is clearly slowing – we have now had four consecutive non-farm payroll prints below 300,000, down from an average of over 440,000 in the first half of the year and over 560,000 in 2021. Further, weakness in the household survey could portend weakness in the establishment survey.
More advanced in Europe
The process of settling the recession debate is far more advanced in Europe and the UK where energy-related fragilities, and a real-terms shock for consumers make a hard landing recession our base case. Perhaps we should not be surprised that recessionary pricing has already arisen in parts of European and UK spread products – which gave attractive portfolio opportunities in the past few weeks – while it has not yet arrived in the US.
European and UK events are a reminder of the good news amid the economic gloom is that recessions provide opportunity in fixed income: first in government bonds, then in credit. As we highlighted just before the recent October yield peak, 2022 is already the worst year for fixed income total returns for years. There is scope for 2023 to see some reversal and, depending on entry points, we expect double-digit returns across several parts of the high quality fixed income spectrum.
The recession we expect is different to the recessions of the past 35 years in that it is likely to occur with inflation substantially above target. While we have seen recessions with high headline CPI in their midst this century (e.g. summer 2008), the differences this time are sufficiently large that the roadmap and price actions of the recessions around the 1970s are more relevant.
Yet even in the four recessions of the 1968-82 era, bond yields fell materially. Recessions by definition mean negative quarter/quarter real GDP, eventual central bank cuts and cyclical pullbacks in inflation. By March 2023, on current pricing, year-on-year oil price changes are set to be negative. We forecast close to zero inflation from US goods prices by June and our analysis suggests even rent price inflation will start to roll over later in H1 2023. Whatever happens to inflation over the secular horizon, 2023 should be a year where cyclical patterns dominate, leading to positive returns from high-quality government bonds.
As for portfolio construction, and how best to take advantage of better markets in due course, we continue to draw a distinction between the merits of yield curve versus duration strategies.
Yield curves versus duration strategies
As we have mentioned before, to be profitable with large-duration trades, you have to call not one but two things right: the cyclical outlook for growth, and the secular outlook for inflation. Yet for yield curves, the cyclical outlook dominates, because inflation premia exist across much of the yield curve, and the secular level of rates and inflation is in any case somewhat embedded in official rates.
We do not mean to be blasé about the challenges of getting yield curve trades right (entry points are hard to time precisely); we just believe that valuations are easier to identify when a fixed income asset is dominated by cyclical mean reversion (yield curves) and is more insulated from secular uncertainty (duration). We think there is much more visibility in the data on the cyclical growth outlook, whereas we are humble about different scenarios in the secular inflation outlook.
It has been widely noticed that the US (and several other) yield curves are at their most inverted in 40 years. To be clear, this makes sense to us, as the inflation backdrop has necessitated a central bank response where rates are taken above estimated neutral levels. That in turn tends to lead to inverted curves, just as it did between 1968 and 1982. What always followed, however, was a cyclical mean reversion to positively sloped curves. We see no reason for that pattern to differ this time, particularly if growth stalls, leading central banks need to address the growth side of their mandates later in 2023 and 2024.
Market segmentation and cross-market opportunities
The second rates strategy we prefer over and above duration is cross-market. We detail the current opportunities that we see in the Rates strategy section. In brief, from an investment philosophy perspective, not all fixed income market players are able to look at, for instance, Australia versus the US. Not all have the liquidity or nimbleness to trade, for example, Sweden.
And not all have the mandate flexibility to trade local emerging market (EM) debt such as Mexico, versus AAA/AA markets such as Canada. In the wake of central bank intervention in 2020-2021 followed by the volatility that has hit bond markets in 2022, many of these relationships are at two to three-decade extremes, creating attractive opportunities.