Last quarter saw the Russian invasion of Ukraine, causing a humanitarian crisis that will have long-lasting consequences, and one that has significantly reshaped the geopolitical landscape. The events that unfolded sent shockwaves across markets, weighing on risky assets, and putting central banks under the spotlight, with inflation spiking on the back of higher commodity prices.
Against this backdrop, Steve Ellis, Global CIO Fixed Income, Fidelity International, provides his outlook for the bond market and why the team is choosing to focus on inflation protection, high quality credit and Asia.
“In March we saw a partial recovery in risky assets, notably equities and credit. Bond markets, however, do not share the same optimism. The repercussions of the war and the impact of high energy prices on confidence, consumption and corporate margins are yet to fully materialise. As central banks strengthen their hawkish rhetoric even further, fixed income investors are acutely aware of the growth risks that still lie ahead.
“The inversion of the US yield curve that we saw this month is the latest signal that markets are sending to central banks that they will soon face some difficult choices, with slower growth ahead. Central banks, and investors, should not ignore the yield curve and what it is telling us, with recession tail risks still looming and some caution required, particularly by monetary policymakers.
“Our focus is on inflation protection, high quality credit and Asia. Fixed income investors should not fear duration. The upside for nominal yields will likely be capped by debt refinancing constraints, central bank actions and demand for safe havens. At the same time, inflationary pressures are unlikely to subside anytime soon. Investors who want to retain the diversification benefits of duration while protecting their portfolios against inflationary risks will find in inflation-linked bonds a good solution in this environment.
“High quality credit markets offer some good opportunity for income generation and capital appreciation, with spreads still wide compared to historical averages. On the other hand, some caution is required in high yield, given its high correlation to risk sentiment, and following the rebound in spreads in March.
“We continue to look favourably to Asian assets, and China in particular. While not immune to broader market volatility, Chinese government bonds offer attractive yield and diversification benefits compared to other government bond markets. Chinese policy remains in focus, and will likely become more supportive in the months ahead, as authorities might move away from the “zero-COVID” policy, combined with stimulus on the monetary and fiscal policy front, as well as property and credit markets.
Central banks face challenging balancing act due to stagflation
“Stagflationary dynamics were in place even before the war. Central banks, particularly the Fed, are focused on bringing inflation. They will have to tighten policy sufficiently to reduce demand, but this could lead to further weakness for risk assets. Policy makers are facing a particularly challenging balancing act and the cost of a policy mistake this year will be high.
“The market is increasingly pricing in front-loaded rate hikes, and a divergence in policy between the US/UK and Europe. In the US, the Fed has shifted its interest rates forecasts considerably and signalled its willingness to forgo some employment focus to control inflation. As a result, traders have quickly switched to the prospect of the Fed conducting hikes in 50 basis point increments at the May, June and July meetings, which would deliver a base rate of 2.5-2.75% by year end. The fact that the 10-year minus 2-year yield spread (2s10s) inverted briefly in March indicates the recessionary dangers posed by increasing rates too fast. We are relatively dovish compared to the Fed’s views and market pricing and expect 4-5 rate hikes in 2022.
“In the UK, the rhetoric from Bank of England is that policy is very much data dependent, but events can move quickly, and we could be approaching a sharp slowdown. With UK equity markets not far off their recent highs, it may be investment grade credit, rather than Gilts, that’s the safest UK asset class.
“The ECB is facing more acute growth risks. We expect a dovish pivot in one of the upcoming meetings as the effect on growth from the war becomes more apparent in the data. There may not be a rate hike this year or we could see a hike to zero and then a freeze. The Governing Council has made it clear that the sequencing remains unchanged, with the Asset Purchase Programme (APP) programme that should come to an end before rate hikes can be considered. This condition challenges the current market pricing, and leaves peripheral government bonds in the crosshairs, due to their sensitivity to risky assets and the tailwind they received from the APP programme over the years.
“Our views leave us on balance constructive on duration on a discretionary basis, partially offset by our quant model’s short position, on the back of momentum and commodity signals. At regional level, our preference is for core European duration, with the European economy more exposed to the war through the commodity channel. With the market pricing a 1.25% terminal rate in Europe, there is limited upside for Bund yields from here. In US Treasuries and UK Gilts, meanwhile, we remain neutral but looking to add on further dips, given the number of rate hikes already priced in by the market.
“Lastly, we retain a defensive stance towards peripheral sovereign debt in Europe, due to its higher beta to risky assets and the sensitivity to any reduction in the APP that the ECB may announce in the months ahead.”