Global bonds navigator: piloting a soft landing

Welcome to the first edition of our bond market forecast analysis. This report is based on the scenario analysis run by the Global Bonds Team to guide 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).

Treading a fine line between policy error and soft landing

After the worst start to the year in history, things can only get better. Right? But with more hawkish language from central banks and growth starting to fade, the global economy is now treading a very fine line between policy error and soft landing. The chance of policy error has grown over recent months as central bankers have had to aggressively hike rates to try and tame inflation. But have we forgotten monetary policy usually works with a lag? Although inflation has continued to beat expectations, there are now numerous indicators signalling a reduction of the supply/demand imbalance that had stoked prices since the pandemic. Freight rates are falling dramatically ­– with new ships and capacity all expected to step up next year – while commodity prices are in decline, and finally, the PMI and ISM surveys have started to indicate economic output is slowing around the world.

Figure 1: Inflation remains stubbornly high with energy and food as key drivers

Source:   Janus Henderson Investors, Bloomberg, as at 30 June 2022. Notes: OECD major seven economies CPI.

The conflict in Russia continues to cloud the economic outlook, however. Should Russia follow through on threats to cut off gas to Europe, the resulting chilling effect on growth would be felt globally.  

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 growth scenarios.   

Our base case over the next 12 months to end of June 2023 is that the global economy enters a recession largely due to the conflict in Ukraine and weakening consumer spending as real incomes are eroded by inflation, with labour market pressures moderating. In the US for example, we model core inflation peaking in September and falling to around 3.3% at the end of the period, limiting the need for additional rate hikes in 2023. 

Overall, the chances of more growth lengthening this current growth cycle are looking increasing unlikely. To put this in context, we only see a one in three chance of either of our two growth scenarios materialising.

Base case (shallow recession):

• Growth slows to a standstill as consumers curtail spending due to falling real incomes.
• Inflation (core personal consumption expenditure) peaks in the third quarter of 2022 and starts to taper off to 3.3% at the end of the period.
• Unemployment starts to pick up near the end of our 12-month forecast horizon.
• After continuing to hike over the third quarter, central bankers start to dial back their hawkish tone in the face of slowing growth. While risk assets perform in this scenario, default rates and liquidity premia have been lifted. Much of the positive returns for risk assets is a function of the wide starting point for spreads.

Bear case (deeper recession):

• Global recession that hits Europe especially hard (-1% for EU and 0% for US over the year) due to energy market supply shocks triggered by the Russia-Ukraine conflict.
• Unemployment rises much higher than our base case.
• Markets roll back their interest rate expectations as central bankers pause hikes and quantitative tightening to head off slowing growth. Credit spreads are volatile and defaults rise, especially in the high yield sector.

Bull case (high pressure economy):

• Growth continues to remain buoyant, which puts upward pressure on wages and causes inflation to settle higher at the end of our forecast horizon.
• Strong labour markets and resilient inflation forces central banks to continue to raise rates.
• Elevated market volatility transpires as more hikes are priced in, while risk asset performance is mixed. Investment grade (IG) assets underperform on a higher rate scenario, but high yield (HY) and lower duration-sensitive assets perform on better growth.

Extreme bull case (armistice):

• Growth picks up and the global economy largely avoids falling into a recession, as Russia-Ukraine conflict settles down, triggering some sanction relief on specific commodities.
• Inflation moderates as commodity prices fall from recent highs.
• Central bankers initially continue to raise rates but back off from tightening due to less inflationary pressures. Risk assets benefit from the fall in conflict-driven uncertainty.

Figure 2: Expected fair values and key economic variables by scenario

Source: Janus Henderson Investors, 21 July 2022. *Average for US/EU GDP growth over the 12-month period. There is no guarantee that past trends will continue, or forecasts will be realised.

Significant lift in forward-looking returns

2022 has been the worst start to any year on record for fixed income total returns. Nevertheless, rate hikes and wider credit spreads have significantly improved forward-looking returns (as shown by the positive expected returns in the base case scenario). Moreover, there is currently no single asset class that particularly stands out as being particularly mispriced. As such, we see benefits in asset diversification at this point in the economic cycle, not least given the uncertainties around economic outcomes and central bank policy. 

Figure 3: 12-month fixed income sector return outlook  

Legend: 1-year sector return estimates (%) in each scenario

Source:   Janus Henderson Investors, as at 21 July 2022. Note:*Bull (bear) refers to a positive (negative) outturn for economic performance. Expected returns for a US dollar-based investor, based on index returns before allowance for alpha. Any differences among portfolio securities currencies, share class currencies, and your home currency will expose you to currency risk. The above are the portfolio managers’ views and should not be construed as advice and may not reflect other opinions in the organisation. There is no guarantee that past trends will continue, or forecasts will be realised.

Key findings:

• Core government bond duration has a greater role to play in portfolios. In three out of four scenarios, central bank rate hikes are at or below what is priced in over next 12 months, as shown for the US in figure 4 (except for extreme bull case scenario). This suggests that on balance, there is room for shorter-term bonds, in particular, to outperform as aggressive rate expectations fail to materialise. On a probability weighted basis, the weighted average yield for the 10-year Treasury is 2.8% in the US (figure 5) and 0.9% in Germany, which is lower than what is priced into the swap markets at time of writing¹.

Figure 4: US Fed rate hikes over next 12 months (bps)

Note: no rate hikes are expected in the ‘Deep recession’ scenario.
Source: Janus Henderson Investors, 21 July 2022. There is no guarantee that past trends will continue, or forecasts will be realised.

Figure 5: US 10‑year Treasury yield forecast by scenario (%)

• Higher quality assets – such as Agency MBS, investment grade assets and government bonds – are beneficial in a slower growth environment (in both a shallow and deep recession), providing resilient returns in all but the bull case, the more severe inflation scenario (where the longer duration of some of these markets continues to act as a drag).
• On a regional basis, European investment grade, government and high yield bonds are on average more likely to outperform US counterparts in the modelled scenarios (on a currency hedged basis) due to the wider starting level of spreads and lower neutral level of interest rates².
• Senior floating rate asset-backed securities (ABS) continue to offer resilience across the scenarios, but less upside in returns overall; so can continue to play a role as a defensive ‘carry’ asset.

Diversification is key

Considering the recent sell-off, our base case favours a broad investment mix, predicated on the yields now on offer and the benefits of diversification to mitigate risk and enhance potential returns. Although we think returns will be more challenging should the global economy fall into a deep recession, we see potential for corporate and government bonds to deliver mid-single digit returns in our base case.

What we are watching for:

• Inflation trends: the Fed will not pivot towards looser policy, in our view, until we see a clear and persistent change in inflation. The August CPI print will be critical given the downside surprise in the July print.
• Growth trajectory: leading indicators of economic activity (eg, PMIs) to provide a gauge on the speed of the growth slowdown; whether in the US, the ISM services PMI (July = above trend growth of 56.7) will ‘catch down’ to the S&P services PMI (July= a recessionary 47.3). Further yield curve inversion at the front end of the yield curve (a recessionary signal).
• Market behaviour: measures of market volatility such as VIX and MOVE³, to subside over the third quarter, which provides some period of stability in credit spreads in the second half of the year in the base case.

Footnotes

¹ Source: Bloomberg, according to the US Treasury Actives Curve and EUR German Sovereign Curve as at 12 August 2022.
² This is the rate that supports the economy at full employment while keeping inflation constant.
³ VIX is a measure of the stock market’s expectation of volatility based on S&P 500 index. MOVE measures Treasury rate volatility through options pricing.