For investment professionals only
Author: Ben Lord, M&G Investments
As we look ahead to the second half of 2023 we maintain a positive outlook for fixed income markets. With inflation expected to gradually come down, and with the end of the interest rate hiking cycle now in sight, we think fixed income continues to offer an attractive entry point for investors. That said, the macro backdrop remains uncertain and we think a flexible approach to asset allocation will be increasingly important in order to capitalise on the most compelling risk/return opportunities across global bond markets.
Inflation is likely to continue to be the key driver of fixed income markets, although we are now seeing clear signs that we are past the peak. This is certainly the case in the US, where the Consumer Price Index (CPI) figures for April dropped to 4.9% on an annualised basis, while core inflation moderated to 5.5%. Furthermore, it is no longer just a few items that are pushing overall inflation lower, but seems to be a broader trend as evidenced by the recent fall in median CPI. Another encouraging sign is the deceleration in rent prices – rents represent the biggest component of the US inflation basket and this is therefore a key metric we like to monitor.
Therefore, while inflation of around 5% is still elevated and higher than we would like, things do appear to be finally moving in the right direction. Inflationary pressures are easing, a wage-price spiral seems to have been avoided for now, and rent inflation appears to have peaked. It might take a little longer than expected to return to target, but we do seem to be on the right track.
Against this backdrop, we believe we are nearing the end of the current US interest rate hiking cycle. Based on patterns of tightening cycles since the early 1970s, we think hiking will stop once rates move decisively above inflation. This echoes comments by Fed Chairman Jerome Powell’s in September 2022: “You want to be at a place where real rates are positive across the entire yield curve.” With interest rates now at 5% and inflation gradually declining, we believe we have reached this very important juncture for the US economy.
Opportunities in investment grade credit
After a brutal 18 months or so for fixed income markets, we think an environment of easing inflation and lower interest rates should provide a more supportive backdrop going forward. Importantly, after the sharp rise in yields in 2022, fixed income offers a much better starting point, and we believe investors are being well-compensated for taking both interest rate and credit risk. On the other hand, the global economic outlook remains uncertain and we therefore continue to favour more highly-rated, investment grade corporate bonds, which we think should provide a good degree of resilience if do go into a deeper-than-expected recession.
From a fundamental perspective, we think that companies are still in good shape and investors are being well-compensated for any reasonable expectation of default. Furthermore, by providing exposure to both interest rates and credit, we believe investment grade corporate bonds offer natural diversification qualities and can provide a source of resilience during uncertain market conditions. While 2022 was an exception, credit spreads and interest rates typically move in opposite directions to one another, and we believe this inverse correlation can offer a valuable cushion against adverse market movements.
For instance, while credit spreads may be expected to widen during a recessionary period as corporate fundamentals deteriorate, we would normally expect this to be offset by a fall in government bond yields as markets anticipate a cut in interest rates to boost growth. We believe these separate interest rate and spread components can provide a more diversified source of returns throughout the economic cycle.
We would also highlight the significant dispersion we continue to see within credit markets. Looking across global bond markets, we see many instances of bonds with similar levels of credit risk but trading at very different valuations. This is often the case during periods of market volatility, but for active managers with access to a large and experienced team of credit analysts, this sort of environment can provide an abundance of opportunities.
Navigating an uncertain economic outlook
Given the current level of corporate bond yields – which can range anywhere between 3.5% in euros to 7.5% in the sterling and US dollar markets – we think the asset class has the potential to deliver mid-single digit to high-single digit returns for several years to come. There is clearly likely to be further volatility along the way, but on a long-term view we think investors have the opportunity to lock-in yields at highly attractive levels. While volatility can feel uncomfortable in the short-term, we would stress that it can also create opportunities to capture mispriced securities, particularly for active managers with a well-resourced team of credit analysts.
In term of our broader economic outlook, we do have concerns that we could be about to witness the expiry of the lag from monetary policy action to real economy reaction. This in turn could lead to perhaps a significant downturn in economic data and growth numbers. This cautious economic outlook may appear at odds with our constructive view on corporate bonds. However, we think solid corporate fundamentals, attractive yields and the natural diversification qualities of the asset class should help mitigate the negative impact of slowing growth.
We would finally like to highlight the benefits of taking a global approach to corporate bond investing, rather than narrowly focusing on say sterling or euro bonds. The global economy is desynchronising, and this presents global managers with a broad range of opportunities between regions as they start to diverge on their own economic paths. A global approach also allows to us take advantage of the relative value opportunities that can exist between regions in terms of the credit spreads available.
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Investments in bonds are affected by interest rates, inflation and credit ratings. It is possible that bond issuers will not pay interest or return the capital. All of these events can reduce the value of bonds held by the fund.
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested.
The views expressed in this document should not be taken as a recommendation, advice or forecast.
For financial advisers only. Not for onward distribution. No other persons should rely on any information contained within. This Financial Promotion is issued by M&G Securities Limited which is authorised and regulated by the Financial Conduct Authority in the UK and provides investment products. The company’s registered office is 10 Fenchurch Avenue, London EC3M 5AG. Registered in England and Wales. Registered Number 90776.
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