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Fixed income

What’s up with inflation and are we entering a new fixed income mini cycle

We entered 2022 expecting some headwinds around inflation, a few interest rate rises in the US, and slowly easing supply chain blockages. And COVID would be a distant memory….or at least endemic. I often sit here as an apologist for Fixed Income (it is my job after all!) given the low and/or negative yields on offer, but despite the headwinds of inflation and slowing economic activity, I believe we are beginning to see the resurgence of the next Fixed Income mini cycle. Whether it is duration or credit is too early to tell at this point.

Inflation. 7 hikes priced in….7 hikes communicated
As you know, we thought inflation was more permanent than transitory last year. The market moved quickly to take that on board. Over the space of about 3 months, the market moved its US interest rate expectations from 2 to 7 rises this year. The US Federal Reserve (Fed) duly delivered, with a 25bps hike last week whilst communicating the chances of further hikes at each of its remaining meetings this year.

US Federal Reserve Chairman, Powell, also said that reducing inflation “may take longer than we like” whilst also confirming that the Fed expected the US economy to grow above trend this year.  We should have seen pressure on markets across the board, given the more hawkish tilt on rates. However, the Nasdaq ended up rallying 4% and the S&P 2%, with Treasuries tightening the morning after.

Perhaps the lack of a big 50bps rise in rates, that in in our view would have been warranted, has settled markets somewhat. There is still the real risk that the Fed is behind the curve. We are also going to see inflation that moves higher than reported numbers given the impact of the war on supply chains and commodity prices.

Inflation will define 2022
Inflation will probably define 2022. The likelihood is that we will continue to see upwards pressure on inflation exacerbated by the events in Ukraine. Raw material costs and food inputs (Ukraine and Russia produce approximately 30% of the world’s wheat) along with huge commodity price inflation will begin to squeeze both living standards and corporate margins. Companies won’t be able to pass on price increases at some point. Furthermore, higher wages will place further pressure on prices.

Can the Fed’s stance of putting the brakes on neutralise monetary policy without triggering a recession? Even with interest rates at 2%, we are still looking at significantly negative interest rates. However, so far, the Fed has not moved into a contractionary policy, which would require far more aggressive hikes, leading to a shrinking economy. That’s our concern.

On the flip side, as we have seen with the large swings in the oil price, if we do have some degree of resolution in Ukraine, and we see WTI oil prices drop back to $90 or lower, plus supply chain elevation, then we may see inflation begin to naturally decline. Also, we are already seeing some effects of higher inflation on consumer behaviour, which will also dampen demand. This is a big ask, but still within the realm of possibility. From our view, we will see the economy begin to slow and that will obviously impact asset prices. We believe that the Fed is likely to move on interest rates pre summer and then pause into the US mid-terms, so 2022 may well be the year of rate rises, and 2023/24 back to easing mode in the face of a slowing economy.

What does this mean for Fixed Income?
In our view, the US would seem to offer the best opportunities at present, given it is shielded to some extent from the cost pressures Europe is seeing from energy prices. Labour shortages and cost continue to be a big issue in the US and obviously interest rates are going up. Much of this bad news is already priced in. This means investment grade bonds and higher quality high yield are beginning to look interesting.

There are still headwinds in terms of inflation and a slowing economic environment, but with a longer-term view, these levels tend to be good entry points. One does need to differentiate between the US and Europe for now, given the differing economic backdrop. It remains to be seen how robust and enduring growth will be in the US, but we believe it seems to be a better environment for credit at this point in time.

Portfolio Positioning
Across global fixed income strategies, we have gradually reduced our Emerging Markets (EM) exposure over the last several months with the view that EM was not offering enough of a discount to Developed Markets given the elevated idiosyncratic risk.

Our duration hedges have moved from the 10 to the 5-year part of the curve in the US, given interest rate expectations and therefore, pressure on the shorter end of the curve. In Europe we have 10-year Bund hedges on. We have also hedged out some of the High Yield risk, although the High Yield market has remained determinedly resilient so far.

We continue to focus on making sure our holdings are robust enough for the inflationary and supply chain headwinds we are seeing.

Outlook
We could see some consolidation on any kind of ceasefire between Russia and Ukraine. However, the likelihood is that markets will continue to be volatile. At this point we are beginning to look for opportunities given how much bad news is being priced in. Caution continues to be the watchword as we wait for more inflation data.

The good news is that we are still at the beginning of the year, and there is still all to play for. Risks are elevated but so is volatility, and that tends to present opportunities for actively managed funds.

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