Head of US Fixed Income Greg Wilensky expects economic growth, inflation and monetary policy to reach equilibrium in 2022 and believes the uncertainties on the horizon reinforce the value of maintaining an allocation to high-quality bonds.
- The emergence of the COVID-19 Omicron variant is a reminder to expect the unexpected and highlights the value of including high-quality bonds in an investor’s overall portfolio.
- Nevertheless, our base case is that economic growth, inflation and monetary policy are likely to achieve an equilibrium in 2022 without substantial market volatility.
- However, active management will remain key, whether to navigate tactical opportunities resulting from an external shock or identifying opportunities for incremental returns in sector, industry and security selection.
2020 taught us all the importance of expecting the unexpected and thus the value of maintaining an allocation to bonds. Additionally, it highlighted the benefits of diversifying investment risk within a bond portfolio, balancing positions taken based on more top-down, macroeconomic views with careful industry and security selection decisions driven by fundamental research.
As we look ahead to 2022, we haven’t forgotten these lessons and, unfortunately, the recent emergence of the COVID-19 Omicron variant could prove yet another example of an unexpected disruption. Even if it does not, other external factors, such as slower-than-expected economic growth in China, or the combination of supply-chain problems and wage pressures in the US, could yet cause disruption. In either event, one would typically expect equities to be weaker, and bonds to rally. While it is not our base case that any of these events significantly disrupt the global economy, surprises do happen, and thus maintaining interest rate exposure, even at low yields, could again prove to help smooth the returns of an investor’s overall portfolio.
These caveats aside, we expect 2022 is likely to be a year of finding balance. In the US economy, we expect economic growth will moderate in 2022 but still remain strong. As such, we expect the US Federal Reserve (Fed) to complete their tapering of bond purchases and raise interest rates but remain accommodative. Furthermore, we expect inflation will stay elevated, but gradually decline as the difficulties of reopening a global economy after a pandemic begin to fade. In short, we expect economies and markets will spend much of 2022 finding the right balance between economic growth, inflation and monetary policy. As such, bond returns in 2022 are likely to be largely determined by how volatile the process will be – how well or badly the transition to trend growth and inflation is managed by the Fed and perceived by the market.
We continue to believe longer-maturity interest rates are too low for the kind of economic growth we are forecasting. As of this writing, the forward yield of the 10-year Treasury is around 1.7% at the end of 2022 – not much higher than current levels1. We believe there is a much larger probability that yields exceed 1.7% and are more likely to exceed 2% by year-end.
However, the most appropriate level for rates is largely dependent on how much inflation moderates. We continue to believe most of the recent rise in inflation will prove to be transitory but expect that some residual effects will persist. To quantify that, we expect the Consumer Price Index (CPI) will rise by 2.75% to 3.0% in 2022 and take another year or two to finally settle below 2.5%. However, current levels in Treasury Inflation Protected Securities (TIPS) and Treasuries are implying that inflation with stay above 2.5% until at least 20252. How 10-year yields can be forecast, by the bond markets, to end 2022 near 1.7% while simultaneously forecasting inflation between 2.5% to 3.0% for the next three years is something of a mystery. Ultimately, we believe the mystery will be resolved through a combination of falling inflation expectations (because we think they are too high) and higher Treasury yields (because we think they are likely to end 2022 above current expectations).
It is important to note that we don’t believe rising yields or changes to inflation expectations necessarily imply rising volatility. When the short-maturity interest rate futures accelerated the timing of rate hikes, it didn’t derail the overall fixed income or equity markets. We think this is because the markets still trust the Fed to navigate policy through this unusual recovery. Because, to their credit, the Fed has been very clear that are willing to be patient, tolerating some symmetrical risk around their base-case forecasts, which should encourage the markets to be equally patient. Ultimately, we believe the Fed wants to remain accommodative, will err on the side of stronger economic growth and will not look to “preemptively” raise interest rates.
Meanwhile, longer-dated Treasuries are likely to remain attractive relative to other developed markets’ government bonds. We expect continued demand from foreigners will be a stabiliser in times of volatility, acting as a brake on any rapid rises in yields. Additionally, institutional investors such as pension funds that have generated strong returns from both equities and bonds in the past year may be more inclined to “de-risk” their asset allocations, reducing equities in favour of bonds if bonds spike, creating more attractive entry levels.
Turning to the credit markets, even after the recent spread widening, spreads in many sectors look rich versus historical averages but we expect they too will tolerate uncertainty with patience. Investors’ thirst for yield is likely to provide support to credit markets and, fundamentally, the combination of low borrowing costs and an economic rebound have resulted in forecast default rates in riskier markets, such as high yield, plumbing new lows.
While 2022 may sound like a particularly tricky year for bond investing (if only because navigating inflation and a rate-hiking cycle are never easy) we think bonds will continue to offer opportunities to add value while maintaining their traditional role as a diversifier in volatile times. In fact, we think 2022 may play to the active manager’s strengths. If a shock – such as from the rapid spread of the Omicron variant – spurs volatility, active management becomes critical. And should this, or other, shocks prove transitory we expect both inflation and the interest rate markets will find their equilibrium, and credit market spreads will remain relatively stable. As such, we believe that the opportunities to add incremental returns to a bond portfolio in 2022 are more likely to come from relative-value opportunities, more nuanced sector allocation and individual security selection.
Bond yield: the level of income on a security, typically expressed as a percentage rate. Note, lower bond yields mean higher prices and vice versa.
Credit: refers to bonds within fixed income markets where the borrower is not a sovereign or government entity. Typically, the borrower will be a company or an individual, and the borrowings will be in the form of bonds, loans or other fixed interest asset classes.
Credit market: a marketplace for investment in corporate bonds and associated derivatives.
Credit spread is the difference in yield between securities with similar maturity but different credit quality. Widening spreads generally indicate deteriorating creditworthiness of corporate borrowers and narrowing indicate improving.
Default: the failure of a debtor (such as a bond issuer) to pay interest or to return an original amount loaned when due.
Inflation: the rate at which the prices of goods and services are rising in an economy. The CPI and RPI are two common measures. The opposite of deflation.
Monetary policy: The policies of a central bank, aimed at influencing the level of inflation and growth in an economy. It includes controlling interest rates and the supply of money. Monetary stimulus refers to a central bank increasing the supply of money and lowering borrowing costs. Monetary tightening refers to central bank activity aimed at curbing inflation and slowing down growth in the economy by raising interest rates and reducing the supply of money.
1Bloomberg, as of 30 November 2021.
2Bloomberg, as of 30 November 2021.
2022 Investment Outlook
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