With a new year fast approaching, we sat down with the Henley Fixed Interest Team to hear their views for 2022. What are they most excited about? What challenges are on the horizon? And what can we expect from markets in the coming months?
What excites you about the year ahead?
As fixed income investors, we have a natural interest in macroeconomics. For that reason alone, there is a lot to think about as we head into next year.
While we all closely follow the monthly economic data cycle, sometimes stepping back and taking a broader view is helpful. The question we are grappling with is: to what extent are we moving into a new economic and monetary policy backdrop?
For a long time now, inflation has been very low and interest rates have hit rock bottom. However, this prevailing backdrop is now under threat, as a result of strong money and credit growth, supply side pressures, rising energy costs, and highly accommodative monetary and fiscal policy.
Of course, this may make life quite difficult for many fixed income investors. If a more inflationary backdrop does emerge, fixed income investors are likely to suffer – either through an erosion of real wealth or by price adjustments in the markets.
However, it is not so black and white. For portfolios that approach this market with cash and a low-risk posture in duration and credit, there could be opportunities. Of course, there have been several false starts down the years. Yields never reached their pre-financial crisis levels and, while we must all be weary of the ‘this time it’s different’ prognosis, there is a sense that we could be in for an interesting period.
Do you foresee any potential challenges? How will you look to combat these?
We think the greatest challenge will emanate from government bonds, rather than credit markets. As mentioned, there’s good reason to think that inflation may be a feature of the landscape in a way it hasn’t been for many years.
The US Federal Reserve has downplayed the current elevated rate of inflation, characterising it as transitory. However, even if supply-side issues can be smoothed over time, the very strong rates of money and credit growth may have longer lasting effects. The trick is to decipher what’s temporary and what’s persistent.
It may be the case that government bond markets can adjust slowly to higher inflation without too much disruption – the Goldilocks scenario. However, we know that markets don’t always evolve in that way. We also believe there is the prospect of a much sharper upward move in yields that could easily unsettle credit and equity markets.
While none of this is set in stone, the risk is clearly there. Yields in all fixed income markets are still very low and, against this backdrop, it feels as though a defensive and patient approach is prudent. In our portfolios, we are defensive in duration and credit.
What are your long- and short-term views?
Short term, it is key that we look in the monthly economic data for evidence that inflation is not going away and that it is feeding into wages. US treasury yields have been moving higher in recent weeks, which may present small tactical opportunities here and there. But we would like to see quite a bit more adjustment in the bond markets before we are willing to significantly increase duration risk.
In credit markets, the short-term strategy is to keep our risk profile low and look for relative value on a bond-by-bond basis. At the moment, there is no real sign of pressure or excess value in the credit market. While primary markets are still pretty busy, much of the new issue market is too expensive for our taste.
One area that we have added to recently is subordinated bank paper. This has shorter call dates and higher reset interest rates. We are in a period when banks can raise capital on good terms. It is easy to imagine that conditions will not be so favourable to these issuers at call dates several years from now. They may then be tempted to avoid calling their bonds, leaving investors holding relatively unattractive securities.
Longer term, we need to stay true to our investment approach, which is to increase both credit and duration risk when the balance of risk and reward becomes favourable. This is easier said than done, as markets often offer compelling value at the point of greatest perceived risk. Of course, the flip side of that coin is to maintain the discipline of reducing risk, even when the perception of risk is very low and yields don’t offer much.