By Paul Grainger
As an asset class, fixed income is often seen as equities’ boring cousin, particularly over the past decade of low yields. Recent months, however, have been anything but boring, albeit for the wrong reasons.
Bonds have seen a record decline, but may now be presenting some of the best value in many years. This coincides with the economic environment becoming more supportive of the asset class.
There are three main reasons why bonds are particularly attractive at the moment:
1. Valuations: yield levels are appealing again and there is good return potential here.
2. Bonds are a good diversifier, particular in periods of economic uncertainty.
3. We believe that the number of rate hikes currently priced into bond markets won’t be delivered as inflation peaks and growth slows.
What has driven the drawdown in bonds?
Between January 2021 and mid-May 2022, global fixed income declined -17.6% (Bloomberg Global Aggregate Bond Index), the biggest drop since data began in 1990. In comparison, the peak to trough decline during the 2008 Global Financial Crisis was -10.8% (see chart).
Record decline creating value in bonds
Since the start of 2022, bonds have found themselves facing a combination of multi-decade high inflation and a hawkish shift from the major central banks. A change in rhetoric and messaging from policymakers has translated into realised rate hikes.
The narrative on inflation has shifted decisively. Prior to mid-2021, central banks were convinced high inflation would prove transitory, as a by-product of Covid-related pent up demand and supply chain disruption.
However, policy makers have become increasingly uncomfortable with the prolonged nature of inflation, particularly given signs of second-round effects feeding through into wage growth.
Added to this is the uncertainty surrounding the war in Ukraine, and the ongoing Covid pandemic, with parts of China currently under stringent lockdowns.
From a purely economic or investment perspective, these factors are fuelling already potent inflationary forces as additional supply side constraints and disruption drive commodity prices higher.
Stunning market move
It is not surprising bonds have suffered given these circumstances, but the velocity of the move has been staggering. In some instances, entire economic cycles have been fully priced into valuations in a matter of weeks.
The move has been more extreme given the starting point. The unprecedented conditions of the past decade or so saw persistently falling and historically low yields.
These historically low yields had left bonds looking broadly uninspiring from a valuation perspective. That has decisively changed. The current turmoil, while painful and unsettling, is increasingly presenting opportunities. Valuations have, in our estimation, overshot macroeconomic fundamentals. Over time, they should revert back.
As well as attractive potential returns, we think concerns over the downside risks to growth could come more to the fore and so too the benefits of bonds as a diversifier to equities. Bonds are well worthy of consideration for investors looking to navigate difficult global conditions and generate income returns.
Aren’t rising interest rates a worry?
Central banks have been signalling preparations to normalise monetary policy conditions for some time now. As rhetoric has shifted and the first hikes have taken place, markets have rapidly discounted substantially higher interest rates.
Some bond market valuations already reflect a full rate hiking cycle, exceeding what is realistic in our view. Over the rest of the year, the implied policy rate (the difference in current yield and the forward rate indicated in the swaps market) is pricing in almost eight rate hikes in the US, five for the UK and even four for the long-term dove, the European Central Bank (ECB)1. The number of rate hikes priced into next year are even higher.
Bonds already pricing in much higher interest rates
It is our view that many of these rate hikes will not be realised and as more investors come round to this view, this will cause government bond yields to fall.
This is based on a number of factors. Firstly, energy and food price inflation act as a tax on consumers globally, with wage increases failing to keep up with the price increases of these staple items. This squeeze on incomes and company profit margins lends itself to a weaker growth outlook, though not necessarily a recession.
The chart below illustrates how rising prices can alter consumer behaviour. Interestingly, higher prices are currently dissuading US consumers from purchasing durable goods, while in the 1970s, despite rising prices, it was seen as a “good time to buy” to avoid even higher prices in the future.
Inflation deterring consumers from spending
Secondly, the lagged impact of central bank tightening will gradually build over the coming months. This will be felt primarily in housing markets globally. Central banks above all want to engineer a soft landing, taking some heat out of the economy without stifling activity. This is an incredibly difficult balancing act. Monetary policy is a blunt tool and its effectiveness works with time lags.
The chart below illustrates a strong correlation between global manufacturing purchasing manager indices – a good measure of economic cyclicality – and tighter monetary policy conditions, with a lag of 12 months.
Our view of the world – growth is slowing
Importantly, the forward-looking nature of bond markets, means that central banks do not need to actually start reversing their current monetary policy stance. All we need to see is the market focusing more on the weaker growth trajectory and less on inflation.
Signs that central bankers are becomingly increasingly wary of the trade-off between controlling inflation and growth is a sure sign that a change in communication is imminent. In fact, we have already seen the Bank of England sound a note of caution on the growth trajectory.
Isn’t high inflation bad for bonds?
In principle, inflation is bad for bonds. The fixed value of bond interest payments and principal is eroded in real terms as inflation rises. However, bond markets have proved efficient and quickly discounted the higher inflation regime. Bond investors are now compensated with higher yields. If inflation were to peak, as we think it will, this would be a big boon for bonds.
Inflation across many economies remains at multi-decade highs. The question is, however, what can drive it higher? Our answer is not much. The supply shock and the resultant higher commodity prices are largely responsible for the price pressures we are seeing. While wage growth does have the ability to feed through into more persistent inflation, nowhere is wage growth keeping pace with goods inflation. This will eventually lead to lower aggregate demand.
The initial resilience of consumers to higher prices might have something to do with their dipping into the savings buffer accumulated through the pandemic. This can only be a temporary solution. At some point, people will have to tighten their purse strings. Signs of waning consumer demand are emerging in some countries, for instance the UK – an economy particularly vulnerable to imported inflation.
There is more uncertainty on the supply side of inflation, but for base effects to work – a fall in the year-on-year level of inflation – we just need to see spot (or realised) inflation stabilise. We are already seeing inflation expectations plateau and inflation measures beginning to surprise to the downside.
Breakeven inflation rates (the difference between nominal and real bond yields) are a good measure of the market’s expectations for inflation. They are starting to roll over as the chart below shows.
Our view of the world – inflation is peaking
Could the market continue to re-price higher inflation and further rate hikes?
It can be uncomfortable going against the market consensus, but by doing so, investors are able to achieve the best possible return potential. Markets are efficient and can quickly move to price in the market or consensus view.
The past has shown that the point of maximum fear has often been the point of maximum opportunity. The chart below shows the percentage return made on an allocation to the Global Aggregate bond index at the low point of previous drawdowns.
Bond valuations offer attractive return potential
Yields are at the most attractive levels for several years. And the income that bonds generate should provide a buffer – or at least some leeway – if yields move higher or credit spreads widen further.
Importantly, global bond markets are now providing attractive all-in total return potential: price gain plus income. The market level mean that bonds offer more scope to protect from capital losses should yields rise further, certainly more so than over the past five years.
Three reasons bonds are back
1. Valuations are attractive following the sharp drawdown, current levels offer attractive total return potential. Even if we are wrong in the short-term and bond yields continue to rise, the increased level of income provide a higher protection to capital loss than we have seen for some time.
2. Given broader global uncertainties around future economic growth global bonds can be a good diversifier as part of a broader portfolio. Indeed, global aggregate by its very nature is also a diverse way to allocate to bonds. The Bloomberg Barclays Global Aggregate index has exposure to over 40 sovereign markets and 20 country issuers of credit.
3. There is increasing evidence that slower global growth will mean that some of the rate hikes assumed by bond market pricing won’t be realised, particularly as it looks likely that inflation is peaking, if not has already peaked. Given the speed of the market move, we truly believe this has opened up a number of very attractive opportunities. It is for these reasons that bonds are back in focus.
Paul Grainger is the Head of Global Fixed Income & Currency at Schroders