Someone is wrong, and someone is right: Franklin Templeton's 2022 market outlook
2021 is likely to be a year many bond investors would choose to forget. The benchmark Bloomberg Global Aggregate Index declined around 4.7% for the year, its weakest performance since 1999 and the domestic Bloomberg Australia Composite Bond Index didn’t fare much better posting a negative 2.9% return.
The soft performance follows a strong 2020, however, and so rolling 2 and 3 year returns for fixed income are still respectable. But 2021 has led to an understandable redux of the question, “Is the bond bull market over?” In other words, are we now facing a steady move higher in yields/fall in prices with 2021 the beginning of a larger move? The short answer is no, or at least, this is highly unlikely.
In fact, we expect solid positive returns for the asset class in 2022, although there is likely to be some volatility in the early parts of the year as markets continue to engage in a tug of war with central bank guidance. The magnitude of tightening from central banks already factored into the bond market makes it difficult for medium to longer-term yields to move materially higher. The many headwinds likely emerging mean that markets are too optimistic as to how much central banks can depart from the current extremely low rate settings.
The global outlook
The most significant question for markets in the year ahead will be to what extent central banks are able to remove the stimulus they put in place over the course of the pandemic. With the benefit of hindsight, it is clear that the mountain of fiscal stimulus unleashed by governments to address the pandemic’s challenges was excessive, with permanent job losses actually quite small and fiscal transfers eclipsing any real loss of income.
As a consequence, ‘inflation pressures’ have emerged but have really been short-term supply-related as a consequence of the pandemic shutdowns and behavioural changes alongside turbo charged fiscal policy.
These will ease in 2022. The staggering rise in prices of select goods, in particular, will stall and likely see short-term disinflation by 2H 2022. Inflation in services will remain muted. By the time interest rate increases are being considered by the Federal Reserve in the United States, it is likely that the pandemic inflation will already be easing alongside other pressure points in the economy.
The considerable monetary stimulus has had a profound impact on equity and credit markets as well as real estate and other asset classes. Global debt levels are considerably higher than the lofty levels before the pandemic.
According to the IMF 2020 alone saw global debt increase by US$28 trillion to US$226 trillion. Global debt to GDP now sits at more than 250% and is ~30% higher than the GFC era.
Emerging markets, particularly China, have accounted for a reasonable proportion of this alongside the major developed markets.
The persistent creation of present demand by purchasing from the future using debt is unsustainable. The broad sensitivity to even small shifts in monetary policy have never been higher. Capturing these realities, yield curves have flattened as 2021 progressed with short term yields moving higher to reflect anticipated central bank tightening, whilst longer term yields have declined from their Q1 2021 highs. The benchmark US 10-year treasury will start 2022 at 1.6% signalling that, at best, a shallow tightening cycle might be delivered. Longer run, growth and inflation dynamics will remain soft.
Risks around China’s economic trajectory remain elevated moving into 2022.
A disorderly attempt to curtail the debt-fuelled construction sector has set off a number of defaults, whilst at the same time authorities appear reluctant to admit defeat and reverse course.
Concurrently, despite China’s population being immunised with a COVID vaccine (albeit one not recognised by Australian health authorities) the country continues to pursue a COVID-zero strategy and retain largely closed borders. Our view is that authorities will need to ease policy in 2022 to avoid a dramatic economic slowdown.
Australia's economic outlook
The Australian economy has fared extremely well during the pandemic, all things considered. There are clearly lingering impacts and damage from prolonged lockdowns, but employment is back to or above pre-pandemic levels and the impact of the pandemic is less severe than previously anticipated. Having slashed interest rates to 0.1% and embarked on quantitative easing, the market is understandably asking why the RBA wouldn’t swiftly look to reverse some of the monetary stimulus in 2022 as others appear close to doing.
We expect QE to ultimately be wound down in 2022 as it is the low hanging fruit of stimulus withdrawal. Actual interest rate increases are unlikely in the year ahead, despite the market already pricing more than three 25 basis point increases to the cash rate. The divergence between market pricing for rate hikes and the guidance from the RBA is arguably the greatest it’s ever been.
The RBA is using the pandemic as an opportunity to keep monetary settings sufficiently loose to finally see wage growth restored to a 3-4% area, a target that has been elusive for many years. Without this, real inflation is unlikely to be in the 2-3% range they aim for, and real wage growth won’t be positive.
The way wages are set and measured means wage growth will almost definitionally take quite some time to gain traction. The market, however, is likely to challenge the RBA’s guidance for a while with the bank’s credibility dented after a disorderly end to its yield curve control in October. Unless the RBA abandons its clear doctrine on wage growth, we expect that market interest rate expectations will eventually adjust to reflect the wage growth guidance of the RBA.
In the meantime, we start the year with yields at the highest levels relative to the cash rate in more than 10 years. This makes bonds very attractive over the medium term as an alternative to cash or short-term investments, whilst recognising that price volatility may persist into the new year.
What's left for credit markets?
Investment-grade credit incrementally underperformed in the latter stages of 2021 and looks relatively attractively priced as the new year commences. Spreads on Australian dollar corporates are at the wider end of their medium to long-term range, excluding the impact of the Q1 2020 selloff. This reflects wider margins to government bonds which, themselves already trading at attractive yields.
The net result of this is that yields on some parts of the investment grade universe are trading in the area of 3.5%. The high quality of the Australian corporate universe coupled with high all-in-yields has restored some attractiveness to the sector and we would expect robust performance over 2022.
Mortgage-backed securities have performed well over 2021, and whilst collateral quality is sound, we expect less upside due to slowing and tight spreads. We are less favourable to high yield bonds which continue to suffer from excessively tight spreads, coupled with the threat of tighter monetary policy.
Overall, 2022 is likely to be a much more respectable year for bond investors than 2021, with the abrupt price adjustment having reset valuations at more attractive levels. It may, however, take time for these dynamics to take hold as the market arm wrestles central bank guidance in the early stages of the new year.
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Andrew Canobi is the director of Australia Fixed Income for Franklin Templeton Fixed Income in Melbourne, Australia. Mr. Canobi is responsible for managing fixed income portfolios including macro strategy formulation, credit research, and...