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July Issue
Ingredients in the mix for a more appetising 2023
INVESTMENT OUTLOOK
Multi-asseT credit: 2023 could be a year of two halves
CREDIT
Bear-case scenario most likely as recession risks loom larger
Macroeconomics
High quality bonds are primed to bloom in 2023
INVESTMENT GRADE
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credit
Read the full article for more analysis of how sticky inflation is likely to be
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Jim Cielinski believes 2023 should bring relief on rates as central bankers recognise their servings of policy tightening are dampening inflation
Andrew Mulliner, CFA Head of Global Aggregate Strategies | Portfolio Manager
ARTICLE AUTHOR
Anyone who has made a béchamel or white sauce will recognise the dilemma facing central bankers. At first the combination of milk, butter, and flour remains a runny liquid. You stir over the heat, but it refuses to thicken. So you add more flour. Nothing happens. You add more flour. Still no response. The temptation is to keep adding flour, but there is a risk. The compounding effect of all that flour, together with the heat, creates a reaction, and all at once the sauce turns far too thick and lumpy. Central bankers’ policy tightening is the flour and the transmission mechanism (how that tightening feeds through to the economy) is the heat. The outlook for the global economy in the year ahead is lumpy as tighter financial conditions provoke material growth slowdowns and recessions. Yet, for many parts of the fixed income market, 2023 could prove to be a far more appetising year.
“The pain in fixed income markets has arguably been frontloaded, much like the US Federal Reserve frontloaded its interest rate hikes”
Figure 1: US inflation and interest rate history
Too hot to handle: dampening excesses in the economy
The past year was unpleasant for fixed income as inflation soared and the distortions to asset prices created by quantitative easing unwound. As central banks stepped back from repressing yields, price discovery returned. Bond yields rose sharply, producing some of the worst total returns in the history of fixed income (1). Yet, the pain in fixed income markets has arguably been frontloaded, much like the US Federal Reserve (Fed) front loaded its interest rate hikes with consecutive 75 basis-point increments. We should not expect the same in 2023. The starting point of higher yields and wider credit spreads should offer a healthier outcome for bond investors. How central bankers calibrate monetary policy to control inflation without causing too much economic damage will dominate markets and we can expect market volatility to persist around their announcements. Previous inflationary episodes are instructive. As Figure 1 shows, the fast pace of US rate hikes in 2022 has only previously been seen under Fed Chairmen Arthur Burns in the mid-1970s and Paul Volcker in 1979 and 1980 – both periods of rampant inflation.
Source:Bloomberg, FRED, 31 January 1960 to 11 November 2022. Federal funds effective rate %, PCE = Core Personal Consumption Expenditures Price Index inflation (excluding energy and food) year-on-year (YoY) % change, CPI = Headline Consumer Price Index inflation YoY % change.
Authored by the Global Structured Debt Team, who are led by:
Seth Meyer Portfolio Manager
Brent Olson Portfolio Manager
ARTICLE AUTHORS
JANUARY 2023
Two things are worth noting:
Both Burns and Volcker began easing when the economy weakened only to raise rates again when inflation remained high. This may incline today’s Fed to retain rates at a high level to avoid repeating this mistake. Rates have historically not peaked until inflation moves below the fed funds rate. So while we expect the Fed to slow the pace of hikes and pause rate increases in coming months, a cut will have to wait until inflation moderates significantly.
• •
For these reasons, and because we expect the US economy to outperform most other developed market economies, we think the Fed will remain tough on tackling inflation. In Europe, the European Central Bank (ECB) and the Bank of England (BoE) may pause their tightening earlier, but even there a resolute focus on inflation will likely keep the hawkish rhetoric flowing for longer than the economies can tolerate.
Sticky business: will inflation recede?
Several factors kept inflation stuck at a high level in 2022, including supply chain problems, the Russia-Ukraine conflict and, in the US, the pass-through of shelter costs in the Consumer Price Index. These should fade, with goods prices leading the decline and base effects making it hard to sustain high year-on-year inflation numbers. We expect inflation in the US to soften but remain above the Fed’s target 2% rate. Europe’s reliance on imported oil and gas aggravates the inflation outlook there, but progress in diversifying energy imports and reducing energy use mean further shocks would be linked to weather or geopolitics.
Jim Cielinski Global Head of Fixed Income
(1) This outlines a global standardised framework to measure GHG emissions from private and public sector operations.
Burns hikes
Volcker hikes
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Multi-asset credit: 2023 could be a year of two halves
Read the full article for the outlook on different fixed income asset classes
The challenge facing investors is deciding which part of the pool to swim in next year, as 2023 could become a tale of two halves, argues Head of Secured Credit Colin Fleury
Navigating the uncertain waters of 2023 requires some caution given that inflation is still running hot and central banks remain in a battle to tame it. In our view, policy tightening effects are yet to fully filter through to consumers and corporate performance. Excess consumer savings in the US, for example, have dipped to lows post their pandemic boom, but spending is softening rather than rolling over. Third-quarter corporate earnings have held up better than expected. We are seeing only early signs of corporate headcount reductions or pressures being felt by individuals as they tackle higher debt service costs from a rising interest rate environment. We have not yet seen the effects come materially through in the performance of the companies we invest in or the collateral pools of consumer credit or mortgages that back securitised assets. That is still to play out, with other risks to the global outlook such as China property sector and COVID challenges and the Russia-Ukraine conflict bubbling in the background.
Fundamentals are treading water
Given such corporate and consumer resilience, we are yet to see a material weakening in credit fundamentals, and markets are not fully pricing in the accompanying recession risk. Spreads have also been supported by an unusual supply-and-demand backdrop, with generally limited debt issuance in 2022. We believe that 2023 could become a tale of two halves, with spreads widening through mid-year as the economic reality of recession seeps through and more appropriately price recession risk. We expect more clarity on the outlook to emerge later in the year. This could include more definitive signs that inflation is getting under control and a pivot from central banks away from policy tightening. Currently the US jobs market, for example, appears to not be cooling enough, given mixed data. Non-farm payrolls growth is starting to moderate, but average hourly earnings ticked up in the November 2022 release.
Figure 1: Mixed signals from US jobs market
Source: Refinitiv Datastream, Janus Henderson Investors, 15 November 2022.
John Kerschner, CFA Head of US Securitised Products; Portfolio Manager
Colin Fleury Head of Secured Credit; Portfolio Manager
Credit
Better yields, more inviting pools
A broad repricing of risk-free yields has made credit more attractive. Regardless of which investment pool you swim in, in our view, it feels sensible to start the year on the safer side. This may mean shifting portfolios ‘up in quality’ by, for example, looking at high-grade securitisation, such as AAA- or AA-rated collateralised loan obligations, and other more senior parts of securitisations in Europe and the US. Nevertheless, the risk of further spread widening will have passthrough even to the high-quality end of the market. So, understanding how much recession risk is priced into spreads today is key for investors. In our view, high grade securitisations are pricing in greater recession risk than other credit markets, particularly as recent rallies on optimism about potential policy pivots (a pause or a slowdown in the pace of interest rate hikes) has seen spreads retrace from their recent wides, US high yield bonds being just one example.
“We are yet to see a material weakening in credit fundamentals, and markets are not fully pricing in the accompanying recession risk”
John Pattullo and Jenna Barnard, Co-Heads of Global Bonds, believe the confluence of attractive yields and an inflection point in rates should make 2023 an opportune year for high quality investment grade and government bonds
Every so often, ideal conditions present themselves. For the titan arum – the world’s largest unbranched flower – it can be anything between two to 10 years between blooms, but when it flowers, the results are impressive. We think high quality investment grade bonds, especially government bonds, are in a similar sweet spot heading into 2023, as a confluence of attractive yields and an inflection point in rates opens up the potential for strong returns.
Figure 1: Yields on government bonds
2023 is an inflection point
Bethany Payne Portfolio Manager
For bond markets, policy tightening in 2022 to tackle inflation was painful as yields rose. Yet the price correction lifted government bond yields back to levels not seen in more than a decade. It was a similar story with investment grade corporate bonds where both credit spreads and yields moved higher.
Attractive yields
Attractive income levels on bonds, however, are only half the picture. We think 2023 will also be an inflection point for the rates cycle – as central banks shift their policy in response to declining inflation and an economic downturn. This means that while we like short-dated bonds, there may be an opportunity cost to holding only short-dated bonds and that is potentially foregoing bigger capital gains from holding longer-dated bonds as rates decline. Bond yields have often overshot when core inflation spikes heading into an economic downturn. This decoupling of government bond yields from economic prospects occurred in late 2022 as bond yields rose despite manufacturing new orders declining (Figure 2). We expect government bond yields to recouple with the economic data. From above 4% in the fourth quarter of 2022, we think the US 10-year government bond yield could be close to 2% by the end of 2023. This could lead to strong capital gains on government bonds and should also have positive implications for better quality investment grade corporate bonds, since these bonds are typically sensitive to rate moves.
Source: Bloomberg, Janus Henderson Investors, Institute for Supply Management (ISM) manufacturing new orders, US 10-year government bond yield, 30 November 1972 to 30 November 2022.
(1) Source: Bloomberg, Janus Henderson Investors, ICE BofA US Corporate Index, ICE BofA 1-3 Year US Corporate Index, at 30 November 2022. Note. The calculation of the breakeven is the yield to worst divided by the modified duration. Basis point (bp) equals 1/100 of a percentage point. 1 bp = 0.01%, 100 bps = 1%. Yields may vary and are not guaranteed.
Read the full article for analysis of why employment figures are likely to take a downward turn
The rapidity and magnitude of central bank tightening caused yield curves to flatten and invert, meaning that shorter-dated bonds are paying similar (if not higher) yields than longer-dated bonds. This is creating a rare opportunity for investors to earn a higher income from holding shorter-dated bonds than longer-dated bonds, while also being exposed to less interest rate risk For example, at the end of November 2022, yields would have to rise by a further 282 basis points (a so-called breakeven) to wipe out the positive total return from shorter-dated US 1-3 year investment grade corporate bonds. This compares with a breakeven rise of 78 basis points for US investment grade corporate bonds in general (1).
“While we like short-dated bonds, there may be an opportunity cost to holding only short-dated bonds”
(1) ECB, June 2022.
(2) Janus Henderson Investors, April 2022.
Figure 2: ISM new orders versus US 10-year government bond yield
Past performance is no guarantee of future results.
Bond yields overshoot when core inflation spikes into growth downturns (circled)
Source: Bloomberg, Generic US Government Bond 10-year yield, Generic UK Government Bond 10-year yield, Generic Germany Government Bond 10-year yield, 1 January 2020 to 29 November 2022.
Yields may vary and are not guaranteed.
There is no guarantee that past trends will continue or forecasts will be realised.
John Pattullo Co-Head of Global Bonds; Portfolio Manager
Jenna Barnard Co-Head of Global Bonds; Portfolio Manager
ISM new orders 6m change
US 10-year yield 6m change (rhs)
Investment GRADE
Read the full article to find out how the carbon intensities of US and European CLOs compare
Getting a comprehensive carbon picture for non-traditional assets can be challenging. Head of Secured Credit Colin Fleury and portfolio manager Denis Struc look at climate-related risks in collateralised loan obligation (CLO) portfolios
The growing importance of assessing the carbon impact of investment portfolios is clear, with increasing ESG standards and reporting requirements globally. However, the scale of the challenges that need surmounting can vary greatly depending on the type of investments. Gathering estimated emissions data for a portfolio of traditional equities or bonds in large global corporations is considerably more straightforward than non-traditional assets, such as a portfolio of loans to smaller and often privately-owned companies or securitised products. This is because a handful of ESG data providers have developed ESG scoring approaches and carbon emissions data capture that is typically focused on traditional asset classes. A typical ESG data provider covers less than 5% of the secured loans market, as measured by the European and US Credit Suisse indices. We have therefore developed bespoke methodologies to estimate emissions from secured loans and corporate credit in general, which can then be applied to collateralised loan obligation (CLO) portfolios.
Such emissions are defined more generally under the greenhouse gas emissions (GHG) Protocol (1)
Denis Struc Portfolio Manager
Greg Wilensky Head of U.S. Fixed Income
Michael Keough Portfolio Manager
Bespoke approach to measuring carbon
Gathering reported corporate carbon emissions across many companies globally and grouping them into granular and representative peer groups forms the basis of our methodology in estimating emissions. This allows us to obtain a reliable average estimation of carbon emissions attributable to a well-defined set of sectors and sub-sectors. Using estimation, we can then efficiently overlay carbon analysis on any portfolio with corporate credit exposure. As we continue our direct corporate engagement efforts, our estimates will gradually be replaced by reported carbon numbers from more companies, further refining our analysis.
“Using estimation, we can efficiently overlay carbon analysis on any portfolio with corporate credit exposure”
Accounting for carbon in CLOs
CLO transactions, being primarily comprised of portfolios of corporate secured loans, naturally fit the approach described above, allowing us to have an early and comprehensive view on the carbon make up of these investments. The largest proportion of carbon emissions in CLO transactions are those related to the underlying corporate borrowers in the CLO collateral pools and are captured at the aggregate level in Scope 3 emissions. In this analysis, we focus on Scope 1 and 2 emissions of those underlying corporate borrowers, represented through the Weighted Average Carbon Intensity (WACI) measure. This information is then aggregated at each CLO overall portfolio level, thus representing Scope 3, or ‘financed emissions’, attributable to these CLO transactions.
Scope 1 accounts for direct emissions from sources that are owned and controlled by an organisation. These would include heating (fuel combustion on site) and company vehicles. Scope 2 accounts for indirect emissions from purchased electricity, heat or cooling, which is used by an organisation. Scope 3 accounts for all other indirect emissions, which are a consequence of the activities of an organisation from sources it does not control (i.e., emissions from downstream and upstream activities such as goods or services that are bought or sold, as well as ‘financed emissions’ attributed to investment portfolios of financial institutions such as banks and asset managers).
• • •
sustainability
Read the full article for more on the different scenarios and which is most likely
Our latest scenario analysis does, however, highlights the more positive outlook for core fixed income
Welcome to the latest edition of our bond market forecast analysis. This report is based on the scenario analysis run by the Global Bonds Team to guide fixed income asset allocation decisions. Each report tries to assess the expected returns potentially delivered by the major fixed income sectors based on a range of modelled outcomes (see appendix for a full description of our methodology).
Jason England Portfolio Manager
Scenarios considered
We adopt a scenario-driven approach to identify the relative attractiveness of fixed income sectors. Our aim is not to perfectly forecast returns to the nearest basis point (as that is not possible), but to understand the range of return outcomes and gauge the resilience of that performance across probable scenarios. Our base case over the year to end of 2023 is that the global economy enters a recession. The speed at which central banks have hiked rates will feed through to the real economy including the housing markets, and consumer spending power weakens as real incomes are eroded by inflation. With tight labour markets, unemployment is not expected to rise as significantly as it did during COVID, but demand destruction results in weak GDP and falling inflation. Although stronger consumer spending stateside and the country’s lower sensitivity to energy price swings helps insulate the US from the worst of the downturn we model, we still expect the US to fall into a recession. Various leading indicators have already signalled that recession is likely. A soft landing is still possible in the US, but the chances are receding. Overall, these two scenarios – recession and soft-landing – account for over 75% of the probability distribution. Inflation falls in all scenarios from current levels to between 1.7% and 4.5% in a year’s time.
Central banks remain laser-focused on current inflation
Across all four scenarios modelled, inflation has either peaked or will do so by early 2023, and fall back sharply from current levels, but to differing degrees. Broad money growth has collapsed (unlike in the inflationary 1970s when it stayed above 10%), supply/demand imbalances that pushed up prices are correcting (e.g. freight rates, used car prices), housing markets are showing price falls and the base effects of energy price rises should bear down on year-on-year inflation numbers (albeit with a longer lag in UK/Europe). Forward looking indicators such as real money supply growth, PMI new orders, and the inverted yield curve point to a sharp downturn ahead, reflecting the lagged effects of tighter monetary policy. Inflation-linked bond real yields made new highs for this cycle since our last report, signalling a tightening of financial conditions. Ultimately, current central bank policy means more rate hikes until inflation shows a more pronounced downward trend, which will be met with demand destruction and a squeeze in real and discretionary incomes.
Figure 1: Fading money growth suggests inflation is heading lower
Source: Refinitiv Datastream, Janus Henderson Investors, 31 January 1965 to 30 November 2022. G7 Consumer Price Index, year-on-year % change, G7 Broad Money growth, year-on-year % change. G7 countries are Canada, France, Italy, Japan, Germany, UK and US. Broad money is the stock of physical cash, bank deposits, money market funds and other monetary instruments held by the private sector.
Helen Anthony CFA Portfolio Manager
Matthew Argent Client Portfolio Manager
macroeconomics
Read the full report for more on the cycle indicators and issuer fundamentals which are informing the outlook for 2023
Credit had a better fourth quarter, delivering positive total returns as spreads tightened on optimism at the apparent passing of peak inflation. A risk-on start to 2023 followed, supported by China reopening hopes and some cooling in the US labour market, but the global economic outlook remains uncertain
As spreads contracted in Q4, our cycle indicator is suggesting that this rally is unlikely to be sustainable. We expect fundamental weakness to proliferate as we move through 2023. Optimism in a central bank retreat has allowed markets to reopen, but this too may prove fleeting. As inflation retreats, real rates will rise, and an inability to borrow at heavily subsidised levels of real rates will worsen the default outlook. We are not out of the woods yet, although the decline in inflation is a critical prerequisite to the elusive soft landing that investors cherish. If a soft landing occurs, correlations within credit could increase. If a hard landing, we would expect to see further dispersion as we go through into the second half of 2023. Careful security selection and building resilience into credit portfolios will be key to navigating this part of the credit cycle.
MARCH 2023
Read the full article for more on defaults and where they are likely to be concentrated
Hard or soft landing? Pivot or pause? While prospects for the global economy remain in the balance, David Milward considers a more predictable element for fixed income investors
Given 2022 was a poor year for fixed income, investors may be re-evaluating credit given the attractive yields on offer today versus history. Higher yields reflect both aggressive tightening by central banks and wider spreads. Such asset allocation decisions are being influenced by conviction towards a hard or soft landing for the global economy – with markets pricing in the optimistic scenario. It’s too early to make a call on this, in our view, and uncertainty lies ahead on growth, inflation and policy. The driver of returns in 2023 thus could be cash interest payments, and investors should be cognisant of this arguably more predictable component. While bond yields have risen, the underlying income (as measured by average coupon) generated in European high yield is at a post global financial crisis (GFC) low given the low yield environment seen for most of the last 15 years (Figure 1). By contrast, European secured loans, as floating rate assets, now generate coupons close to post GFC highs as rising short-term rates lift the cash coupons paid by borrowers.
David Milward Head of Loans, Portfolio Manager
Cash yields in the European loan market now exceed 6% and are expected to increase further as expected central bank tightening is fully reflected in short-term cash rates (Figure 2). With European rates forecasted to rise by around 100bps this year, such income generated for a loan portfolio provides a significant cushion to returns if spreads widen from here.
Loans
Figure 1: Cash interest receipts in European loans supersede high yield
Source: Bloomberg, ICE BAML, Credit Suisse, as at 31 December 2022. ICE BofA Euro High Yield; Credit Suisse Western European Leveraged Loan Index (CS WELLI).
Greg Wilensky CFA, Head of US Fixed Income, Portfolio Manager
Jeremiah Buckley CFA, Portfolio Manager
Source: Janus Henderson Investors, Bloomberg, ICE BAML. Notes: Data is based on 1-month Libor up to 31 December 2020, then SONIA, ESTR, SOFR 1-month rates to 31 December 2022. Forward rates based on overnight index swap (OIS) curves as at 18 January 2023.
Figure 2: Cash rates are expected to rise further
There is no guarantee that past trends will continue, or forecasts will be realised.
USD Cash
EUR Cash
GBP Cash
EU High Yield
EU loans
A more difficult economic backdrop
Investor concerns around rising defaults are understandable, but we’re not anticipating a material spike in defaults this year. Moody’s forecast sub-investment grade defaults to rise to 4% this year (1) in Europe – which is in line with recent averages. While this is a notable increase, it’s certainly not a major negative for the market. It will be important to avoid companies with over-levered balance sheets and limited pricing power in this environment. It is also worth noting that both US and European loans have higher recovery rates (2) than their equivalent high yield markets.
Figure 3: Loans have higher recovery rates than high yield
US high yield
Trailing 12-month par default rate
Trailing 12-month recovery rate
Trailing 12-month default loss rate
US loans
Western European high yield
Western European loans
1.3%
1.1%
0.1%
1.9%
54.7%
61.2%
38.5%
61.8%
0.6%
0.4%
0.06%
0.73%
Source: Credit Suisse, 30 November 2022.
(1) As at 15 December 2022.
(2) Recovery rate is the extent to which principal and accrued interest on defaulted debt can be recovered, expressed as a percentage of face value. HY = high yield.
Spreads are offering adequate compensation for rising default risk, as reflected in current loan discount margins (DMs) – a type of yield-spread calculation designed to estimate the average expected return of a variable-rate security. For example, the 3-year DM of 6.61% (3) for European loans offers a significant cushion against potentially rising defaults.
(3) A measure of the cushion available to absorb any defaults within the portfolio of loans for each tranche of CLO debt. The structures typically allow a portfolio to hold up to 7.5% CCC-rated assets with no consequence (ie. the loans continue to be valued at par for OC purposes). If this limit is breached, then the excess must be priced at market value for the OC tests.
Read the full article for more on where emerging markets may rebound this year
As we move closer to the end of the US hiking cycle, the outlook for emerging markets (EMs) looks brighter in 2023. The Emerging Markets Debt (EMD) Hard Currency (HC) team explore whether EMD HC could become the silver lining amid the global slowdown
The fortunes for EMs next year are largely dependent on the path of inflation, US Federal Reserve (Fed) hawkishness and the depth of the global slowdown. As risk appetite is a key driver of capital flows and thus EMD HC performance, this really matters for investors and is largely defined by the global environment. As US CPI appeared to have peaked in October, this saw a widespread rally across risk assets as optimism was revived – perhaps too much so – for a long-awaited pivot. Overly gloomy markets reversed as global risk aversion halved in November, according to our proprietary JHI Risk Aversion Index (RAI). The EMD HC asset class therefore saw the strongest monthly return since the 1990s (1).
Surpassing peak US inflation was pivotal for markets as it signalled that the end of the US hiking cycle could be on the horizon (in our view by the middle of next year). US Treasury yields tend to hit cycle highs when the Fed pauses hiking (2) and so a peak in yields also comes with less risk of a strong dollar in 2023. Such strength has hampered EM performance – given economies’ exposure to dollar-denominated debt. This is because a stronger dollar has predominantly been accompanied by wider EMD HC spreads. A more constructive environment for the asset class could therefore materialise next year, as risk appetite tends to lift once the hiking is over and uncertainty subsides. The interplay between inflation and economic growth will be key to how investors perceive EM – and ergo valuations – and whether the Fed manages to orchestrate the soft landing it hopes for.
Emerging markets
Figure 1: Risk aversion on a downward trajectory
Source: Janus Henderson Investors, Macrobond, 30 November 2009 to 30 November 2022. First principal component of a broad set of asset prices, i.e. a commonly shared risk component that is not asset class specific which we interpret as a broader representation of market sentiment. A lower score indicates risk aversion has fallen across global assets.
Thomas Haugaard Portfolio Manager
Sorin Pirău Portfolio Manager
Brighter relative growth prospects for EM
As the storm clouds amass for the global slowdown in 2023, investors will likely be considering where to seek shelter. According to the IMF/WEO projections, the EM-US growth differential is set to grow in 2023 and 2024 as EM emerges as relatively unscathed in the broader global slowdown (Figure 2). Structural drivers for EM growth – such as technology and demographics – are more favourable relative to developed markets (DMs). The latter also face the more difficult retracement from years of very loose monetary and fiscal policies. In contrast, EM economies did not have the same firepower to spend while they are also generally ahead in their tightening cycles. This suggests EMs may have monetary policy buffers to draw on in a slowing global economy. The rising EM-US rate differential could be a positive tailwind for tighter EMD spreads as it makes EM relatively attractive from a fundamental perspective.
Source: International Monetary Fund (IMF) and World Economic Outlook (WEO) projections, October 2022, Macrobond.
Figure 2: EM-US growth differential to rise
Bent Lystbæk Portfolio Manager
Jacob Ellinge Nielsen Portfolio Manager
“The rising EM-US rate differential could be a positive tailwind for tighter EMD spreads as it makes EM relatively attractive from a fundamental perspective”
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
2021
2022
2023
2024
7.5
5.0
2.5
0.0
-2.5
-5.0
-7.5
4.0
3.5
3.0
2.0
1.5
1.0
0.5
EM-US growth
Euro Area
Advanced
Percent
World
United States
(1) Source: Bloomberg, monthly total returns according to the J.P. Morgan EMBI Global Diversified Index (EMBIGD), 30 November 2022.
(2) Source: Goldman Sachs Investment Research, Haver Analytics, 28 November 2022.
Read the full article for more on how the market is seemingly ignoring Chairman Powell’s hawkish assertions
Jason England and Daniel Siluk argue that investors need to brace themselves for higher-for-longer interest rates and that a conservative approach toward duration is merited
After a tumultuous 2022, fixed income investors are seeking grains of optimism wherever they can find them, and a modest – but ultimately short-lived – rally off the year’s lows suggested they had unearthed a few. In contrast, we maintain our stance that caution continues to be merited as the calendar turns to 2023. Over the past two years, both policymakers and investors have gotten plenty wrong. Bonds’ recent rally was premised on inflation having peaked and the expectation that the Federal Reserve (Fed) will pivot toward a dovish stance once the US economy slows. While we acknowledge that the worst of inflation is likely behind us, we cannot ignore that its stickiest components – namely wages – remain elevated. We believe the task of guiding inflation back toward the Fed’s 2.0% objective will take longer than the market expects. Consequently, it’s our view that a 2023 policy pivot is not in the cards
Daniel Siluk Portfolio Manager
Not yet out of the woods
The path of inflation, interest rates, and the economy will continue to play a significant role in the bond market until greater visibility into these forces emerges. The chances are slim that the inflation and interest rate disruptions of 2022 will be repeated. Yet, 2022’s resetting of rates has left bonds better positioned to withstand additional shocks. After several years, a fixed income allocation once again has the potential to offer diversification against swings in riskier asset classes, as well as levels of income generation that investors feared had been consigned to the annals of history.
“We think a pivot is unlikely. Fed Chairman Jerome Powell has been resolute in his messaging that guiding inflation back toward 2.0% is his highest priority”
Getting realistic
Some adjustment has been made in resetting expectations as consensus has coalesced around the global economy slowing in 2023. In the US, annualised quarterly economic growth is forecast to range between 0.0% and 1.0% over the year. At these levels, any downside surprise could tilt the economy into recession. This potential outcome is partly responsible for the bond market’s recovery, as bulls expect it would force the Fed to pivot. But we think a pivot is unlikely. Fed Chairman Jerome Powell has been resolute in his messaging that guiding inflation back toward 2.0% is his highest priority. Inflation falling from 9.0% to 5.0% is the easy part, as the baseline effects from strong pandemic-era demand for goods rolls off. The hard part will be getting from 5.0% to 2.0%, especially as the contribution of the wage-heavy services component to overall inflation has increased in recent months. We don’t see any path toward 2.0% inflation that doesn’t involve quelling the demand for labour, which feeds directly into upward wage pressure. As alluded to in the Fed’s most recent projections, the central bank is willing to pay the price of a slowing economy and higher unemployment to maintain credibility and – importantly – avoid the mistakes of the 1970s when a premature dovish pivot only increased inflation’s volatility.
Read the full article for more on why a 60/40 portfolio may be beneficial in the years ahead
Jeremiah Buckley and Greg Wilensky discuss why, despite a challenging year in 2022, they believe the long-term benefits of stock-bond diversification remain intact
“The rumors of my death have been greatly exaggerated.” – Mark Twain (1835-1910) While returns on financial assets in 2022 left many investors frustrated, those holding balanced portfolios have reason to feel particularly aggrieved, having just experienced their worst year of returns since the Global Financial Crisis (GFC). Investors who hold balanced portfolios (typically a 60/40 allocation to stocks and bonds) generally do so because the strategy has, over time, yielded better risk-adjusted returns by limiting drawdowns versus equity-only strategies. The key tenet underlying the balanced approach is that stocks and bonds have historically tended to move in opposite directions during times of financial market stress. The 60/40 portfolio boasts an impressive track record: Prior to 2022, it delivered positive returns in 35 of the previous 41 years. But in 2022, the strategy didn’t work as investors have come to expect, recording a -16.9% return as the Bloomberg US Aggregate Bond Index (US Agg) logged its worst year on record, and the S&P 500® Index simultaneously experienced its seventh-worst year since the Great Depression. Naturally, many investors have started to question whether the game is up, and if traditional stock-bond diversification is dead? Has the multi-decade symbiotic relationship between stocks and bonds come to a bitter and abrupt end?
Correlations: 2022 was not that unusual
As the debate over the balanced portfolio’s future rages on, critics of the 60/40 portfolio have pointed to the sharp increase in the correlation between stock and bond returns in 2022. Their argument? If bonds and stocks are now moving in lockstep with one another, of what use are bonds as a diversifier? In our view, however, investors would do well to consider a longer-term view of correlation. As shown in Figure 2, over the past 30 years, stock-bond correlations have fluctuated significantly on a 1-year rolling basis, and on a 3-year rolling basis have remained either positive or negative for long periods of time. Yet, despite the short-term swings, stock-bond correlation has on average been close to zero. It is not unusual for correlations to rise over the short term and, as such, we do not see evidence to substantiate a theory that the fundamental relationship between stocks and bonds has broken down.
Figure 1: Stocks and bonds have simultaneously experienced negative calendar-year returns in only five of the past 95 years
Source: Bloomberg, Morningstar, NYU Stern, as of December 31, 2022. Notes: S&P 500 Index total returns and 10-year US Treasury Bond total returns, 1928-2022. Blue squares represent years in which both stocks and bonds were down, orange squares represent years in which stocks were up and bonds were down, or bonds were up and stocks were down, or both stocks and bonds were up.
Returns: 2022 was a rarity
In our view, it is vital for investors to grasp how rare 2022 was from a return perspective. Much of the move down in asset prices was triggered by the Federal Reserve’s (Fed) aggressive rate hikes (4.25% within the calendar year) as it sought to rein in runaway inflation. But, as shown in Figure 1, the combined effect of the rate hikes on stocks and bonds was highly unusual, as they both ended the year down for only the fifth time since 1928.
40%
30%
20%
10%
0%
-10%
-20%
US 10-year Treasury calendar year return
S&P 500 calendar year return
-60%
-40%
60%
Stocks down, bonds up
Stocks up bonds up
Stocks up bonds down
Source: Janus Henderson Investors, as of December 31, 2022. Note: Rolling correlation of S&P 500 Index and Bloomberg US Aggregate Bond Index using monthly
Figure 2: Stock-bond correlation (1990 – 2022)
Past performance does not predict future returns.
It is common for correlation to fluctuate, but on average it has been close to zero.
1-year rolling correlation of S&P 500 and US Agg
3-year rolling correlation of S&P 500 and US Agg
Average correlation of S&P 500 and US Agg
“We do not see evidence to substantiate a theory that the fundamental relationship between stocks and bonds has broken down”
