Fixed income outlook: Staying Power

In our Q4 outlook we concluded that ‘it’s hard not to be bullish’. We argued that central banks took a risk by overtightening to win their war against inflation and concluded that this risk management approach to policy was increasing the valuation appeal of bonds. With valuations reaching a 15-year high, we believed that bonds could rally, not only in a recession scenario, which at the time seemed to be regarded by the market as a prerequisite for yields to decline, but also in a soft-landing alternative.

Has this rally already gone too far? It’s tempting to conclude that ‘the easy part’ of the rally could be over, if not for the fact that bond markets weren’t really easy this year. Nonetheless, we believe in the need for staying power to navigate volatility, as we continue to hold the view that yields have room to decline further.

As we believe that the longer-term policy rate discounted by markets still seems too high, we remain constructive on government bonds. Any setback in yields is likely to be used by investors to add to bond exposures. The exception to this is Japan, a country that is facing higher levels of inflation while economic growth remains relatively strong. The BoJ seems to have realized that their policy mix needs to change away from being very easy.

With regard to growth, we retain our below-consensus view as the drag of past rate hikes continues to feed through. We think it seems premature to conclude that a soft landing should now be the base case for the US economy. Furthermore, the Eurozone economy could stagnate for longer than the consensus thinks. We see broad-based evidence in the corporate sector that higher policy rates are impacting the broader economy via corporate defaults and restructurings in both the private and unlisted debt markets. It is not a question of ‘if’ but rather one of ‘when’ the impact of higher interest rates on the broader economy will become apparent.