Jack McIntyre, Fixed Income Portfolio Manager at Brandywine Global, part of Franklin Templeton, provides his outlook on global fixed income for the year ahead.
“Coming into 2022, it appears that from a valuation standpoint, developed market bonds are going to have more of an undervalued bias. It is not an extreme undervaluation that would indicate a need to aggressively buy developed market bonds. Instead, it is a lower-conviction undervalued anomaly. However, it is more pronounced as you move down the yield curve. This anomaly makes sense given that there has been a generalised shift by developed market central banks to remove monetary stimulus and potentially embark on a tightening cycle in 2022. Some central banks already have acted while others are still contemplating tightening, but this will clearly be the trend for 2022. Going forward, monetary policy will no longer be the stimulative tailwind it was in 2020 and 2021. This monetary policy shift certainly makes sense given that inflation has surged and has become “less transitory” along with the number one storyline for the markets and a major concern for investors.
“Meanwhile, the latest pandemic headlines are regaining market influence given the uncertainty associated with the new Omicron variant. The Delta variant was already expected to make a wintertime resurgence in the Northern Hemisphere, so Omicron adds to the pandemic concerns. We suspect in early 2022 we are going to have more clarity on Omicron regarding how contagious it is, the severity of its symptoms, and the efficacy of vaccines. The bond market will continue to adapt accordingly. Providing the new variant does not derail the “learning to live with COVID-19” theme, we expect supply chain bottlenecks to dissipate during the first half of 2022, putting some downward pressure on goods inflation. More shutdowns would clearly prolong the re-opening of the global economy. Even with Omicron, the uncertainty is more along the lines of how governments will react to it as opposed to the variant itself. We see bigger risk in governments overreacting and shutting down certain parts of the economy or that the recovery in the supply chain gets pushed out. The latter is not our base case view, but it is something that we need to watch as it likely would lead to stagflation.
“We are still of the mindset that the pandemic is a global natural disaster and not an economic crisis. However, the fiscal and monetary policy responses have been more in line with an economic crisis given their magnitude and duration. Part of the risk market’s recent angst has to do with the impending removal of monetary stimulus combined with the withdrawal of fiscal stimulus, i.e., the fiscal cliff. Economic recovery tends to be much faster post the end of a natural disaster than for an economic recession.
“If we extend our view for developed market bonds for all of 2022, we cannot get away from the perspective that yields in the long end of the curve should be range bound. We can blame it on two major forces colliding during the year. Amid the re-opening of the economy, waning COVID-19, diminished fiscal stimulus, and dissipating supply bottlenecks, goods inflation should subside. However, service inflation, which is more labor intensive, should rise. We expect the Fed to accelerate its tapering of asset purchases, but rate hikes likely will not happen until the back end of 2022, if at all.
“If we are right about developed market bonds trading in a range in 2022, the real opportunity in global bonds could be in emerging markets, which have lagged for several years. Unlike developed markets, many central banks in developing markets are in mature tightening cycles, and inflation expectations are elevated, which makes their high real yields looks attractive. If goods inflation comes down in the first half of 2022 as we expect, the Fed may abstain from hiking rates or, at the very least, the gap from the end of tapering to the beginning of tightening increases. Since many emerging market central banks have been tightening for an extended period, their bond yields have moved up sharply, resulting in very positive real or inflation-adjusted yields. Therefore, lower inflation in that part of the global economy is good for emerging market assets, including bonds and currencies. Our valuation models for emerging market bonds, unlike developed market bonds, are in the range of “significant” undervalued anomalies. The presence of this significant anomaly does not mean that emerging market bonds are poised to rally in the early portion of 2022, but it highlights that they have “discounted” a tremendous amount of negative information. When this valuation disconnect occurs, the catalyst to change the markets’ views of emerging market bonds can be minor. For example, a shift could be triggered by inflation coming in slightly below expectations. We expect that investors will be adequately compensated for taking an outsized position in duration exposure in emerging market bonds in 2022. Brandywine Global is acting on this view.”