Strengthen your portfolio with flexibility
The past year has seen a historic surge in inflation and interest rates, and a corresponding reset in financial asset valuations. At the start of 2023, we believe that peak inflation has passed, and anticipate a gradual reduction in pricing pressures over the course of the year, even as short-term rates remain elevated. As inflation recedes, quality and security selection could be more important than ever. In this environment, we think maintaining flexibility and adopting a dynamic approach across different fixed income sectors, particularly the spectrum of credit, is an effective way to enhance returns.
After a year of massive global monetary tightening, we expect inflation to retreat further from peak levels, although it is likely to remain well above norms and central bank targets throughout the year and into 2024. As expressed in their meetings and policymaker comments, central banks understand the need to maintain tight conditions in order to tame pricing pressures. So, although we could see just a couple more hikes, U.S. short rates are likely to remain high for some time. In other words, the world of zero interest rates that was so prevalent after the Global Financial Crisis is likely over.
In the U.S., the Fed continues to face a complex inflation picture. Today, COVID-related stimulus still needs to be squeezed out of the system, while generous fiscal outlays continue to operate as an offset to tighter monetary policy. The labor market remains a challenge, as workforce departures have contributed to a labor shortage, inhibiting productivity and adding to wage pressures.
Looking at major components of the Consumer Price Index (CPI), we believe that policymakers have reason to feel confident about goods inflation, which has largely been tamed since the initial pull-forward of demand during pandemic lockdowns. Shelter—which saw rapid increases with stimulus payments and rock-bottom interest rates—seems likely to turn next amid higher mortgage rates and economic slowing. Most uncertain at this point is services (ex-rents) inflation, which is notoriously sticky and may be reinforced by structural elements of the modern economy. To the extent that services hold up well, that increases the likelihood of an economic soft landing, but may make it more difficult to reduce associated wage gains enough to pull inflation down to Fed targets.
We believe much of the Fed’s heavy lifting is in the rearview mirror, and we anticipate that 2023 will see quieter fixed income markets. This could create significant opportunity to capture higher yields with limited risk, especially given the added yield cushion that last year’s repricing created.
We anticipate interest rates to trade within a much tighter range than in 2022, as inflation moderates and central banks hike at a more gradual pace. Second (and related to the first point), duration exposure should be less risky than it was in 2022, with the added benefit of far more generous yields providing a cushion against potential negative total return. However, fundamental concerns about credit are likely to increase, not just due to macro developments, but as a function of individual issuer dynamics and financial positions, making security selection more important than ever.
The focal point of our enthusiasm is the investment grade market. For years, investors needed to push the envelope on duration and credit risk to make up for exceptionally low yields provided by government and other high-quality issues; today the total return potential for 10-year U.S. Treasuries is greater than at any time in over a decade. Meanwhile, the additional spread provided by many quality corporate bonds and other strong credits translate into their highest absolute yields since the Global Financial Crisis.
Despite potential for economic deterioration this year, the picture for default risk is relatively benign. Corporate leverage remains generally lower and cash levels higher than prior to the pandemic. New issuance patterns have been less aggressive, both in their use of proceeds and ratings cohorts. Moreover, given ultralow yields in recent years, many companies were able to extend their maturities at low interest rates and relatively few names will be maturing in 2023 and 2024. That said, general consensus is for an increase in high yield defaults in 2023 – 24, particularly if the recession turns out to be worse than anticipated.
What does that mean for portfolio positioning in credit markets? Credit differentiation will rise as the impact of higher rates and a slower economy filter into actual corporate earnings and outcomes. We expect credit markets to morph from something that was more driven by “macro” outcomes in 2022 to something more tied to fundamental outcomes. A key wild card is whether the mixed picture in economic dynamics could lead to more inflation than anticipated—and thus more difficulty in financial markets. This is not our base case, but it needs to be considered as we press into still uncertain territory. As we’ve seen in recent years, economic data and events can always surprise us—but for fixed income investors, we think 2023 offers more opportunity and much less risk than 2022.
More information on our outlook for Fixed Income is available to download below.
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