With the global economy at a crossroads, bonds could outperform equities this year in two out of three possible scenarios, according to Alexander Pelteshki, fixed income investment manager at Aegon Asset Management.
Pelteshki, co-manager of the Aegon Strategic Bond and Strategic Global Bond Fund, sees three potential outcomes for the global economy, two of which will lead to bonds, which endured one of their worst years ever in 2022, outperforming equities.
“Without assigning probabilities, we can envisage either a continuation of the current ‘Goldilocks’ path, higher inflation than currently expected by the year-end, or larger than anticipated economic slowdown – a recession,” he says.
“The current market path is predicated on the continuous decline of inflation and reasonably okay economic activity lasting into the year-end. As we move through the first half of 2023, markets will likely have to contend with the interplay of these three paths, most likely switching between them a few times along the way.”
If inflation remains higher for longer, however, he says central banks will have to continue hiking. “We will likely see interest rates move higher from here, although it would leave credit spreads largely unscathed, while a recession would likely see credit spreads of riskier debt in particular widen and government bonds rally
“However, in all three scenarios we see solid total returns for fixed income in 2023. Furthermore, for the first time in many years, we also anticipate bonds will do better than equities in two out of these three scenarios.”
1. Government bonds
“Government bonds issued by the UK offer the most relative value. The much-improved energy situation will have a direct impact not only on headline inflation, but also on the amount of government debt to be issued during 2023, which was a major reason behind the 2022 sell-off. The prospects of the gilt market continuing to deliver positive returns are as good as they are for US Treasuries.
“At the other end of the spectrum is the debt issued by the Eurozone countries. Firstly, the ECB is still forecasting negative real yields until 2024. Secondly, we are witnessing rapidly improving economic prospects, where economic recession in 2023 is not the base case anymore and looks increasingly likely to be avoided.
“The continent’s economy is likely to benefit disproportionately from China re-opening, owing to its relatively globalized nature, which could put a renewed upward pressure on economic activity and consumer prices.”
2. Investment grade credit
“The overarching theme of investment grade credit spreads should be one of relative stability, driven by the decline in interest rate volatility. Within that some regional markets look marginally more attractive than others.
“The rapid change of fate for the Eurozone, where markets were pricing-in near certain recession just six weeks ago, is still repricing European corporate credit spreads. From a relative point of view, the prospects for European investment grade bonds look good.
“US investment grade spreads look less interesting than those in the EU. This is mainly because they do not currently price in any probability of recession. While we do not have a US recession as our base case, if this were to occur it would likely reprice spreads somewhat wider from current levels.
“We would not expect that repricing to be either very dramatic or impair the total return prospects of the asset class for 2023, with the yield of the index at 5% still looking as high as it has been in more than a decade.”
3. High yield
“In high yield the direction of credit spreads could be more binary. US high yield credit spreads look vulnerable to a potential widening than EU high yield spreads, both on fundamental grounds as well as from a valuation point of view.
“From a bottom-up perspective, US corporates must refinance maturing debt at a much higher all-in yield relative to European counterparts, owing to the higher US base rates.
“The risks of a major economic slowdown have rapidly turned in favour of the US. US high yield credit spreads look more vulnerable to a potential widening than EU high yield spreads, both on fundamental grounds as well as from a valuation point of view.”