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Fixed income highlights - Policy divergence

In this article:

    In our fixed income outlook, we contrast the Federal Reserve’s forecasts for the US economy against its – modest – projections for the fed funds rate, while highlighting the opportunities in credit, specifically in Europe versus the US and in the banking sector. In emerging markets, our focus is on Asia, and more particularly on local currency Chinese debt.  

    US – More upside to fed funds 

    Looking at the Federal Reserve’s mandate, how close is the US to full employment? 

    • The unemployment rate has fallen sharply, while the employment-to-population ratio has recovered. But the labour force participation rate is off its peak.
    • Workers are voluntarily leaving and switching jobs at high rates – historically, a good indicator of a tight labour market.
    • The tightness is also apparent in compensation metrics. Employers are having to raise wages and improve working conditions to attract workers. 

    The minutes of the December meeting of policymakers suggest that some FOMC members are coming to the conclusion that the economy is near full employment.

    Will higher wages cause inflation to persist? It is worth noting that wages – according to the Atlanta Fed’s Wage Tracker (see exhibit 1) – are rising across the board.

    This comes at a time when the term ‘transitory’ describing inflation is no longer helpful. Inflation is spreading beyond core goods to services. The firmer trend in primary rents and owners’ equivalent rents – a major component of inflation – is likely to last for at least a year.

    Considering the Fed’s forecasts for inflation – as well as growth and employment – we believe its projections for policy rates do not align with those forecasts. It is peculiar that rates should still be below the 2.5% neutral rate estimate by late 2024, with unemployment at just 3.5% and core inflation still above the 2% target.

    So, we expect the Fed to continue to raise its rate guidance as it seeks to return inflation to target.

    The first rate rise could come this March, with moves to follow at every policy meeting taking rates to 2.5% or higher by the end of 2023. By comparison, current market pricing suggests policy rates will peak at around 1.8% in late 2024.

    There are several reasons to foresee a rapid normalisation of policy rates. Household finances are strong, corporate earnings have boomed, the economy is already close to full employment, core inflation is at its highest since the early 1990s, and yet benchmark real 10-year Treasury bond yields are still distinctly negative.

    Eurozone – ECB in no rush

    In the eurozone, we believe the peak in inflation is near. For inflation pressures to be sustained, inflation needs to spill over to wages. We expect wages to pick up further in 2022, but probably not by enough to generate an increase in real disposable income.

    High inflation numbers have led to more hawkish communications from the ECB. It has left the door open for policy rate increases once the pandemic emergency purchase programme (PEPP) ends, while the more established asset purchase programme (APP) still runs.

    The ECB has given itself the option to raise rates as soon as in 2023. We actually expect the ECB to not increase rates before 2024.

    UK – Looking for a steeper curve

    Inflation will likely not peak at least until this April given the improving cyclical outlook, tightness in consumer goods markets and surging utility prices. There are signs that wage increases are continuing, albeit at a slower pace.

    Given these developments and inflation forecasts, we believe the Bank of England will likely follow its December lift-off with a 25bp rate rise in February.

    The UK yield curve could steepen in the medium term as central bank demand for Gilts drops off. Given the BoE’s guidance, we believe it is unlikely for short-dated yields to price in a rate-rising cycle much beyond 1%, while longer-dated yields could rise further on the prospects of BoE asset sales.

    Credit – Europe to outperform

    While US policy rates (and real yields) can be expected to rise in 2022, we do not see this as a meaningful risk to economic growth or corporate profits. Monetary policy is merely normalising.

    At 4% year-on-year in Europe and 9% in the US, 2022 consensus earnings growth estimates are dramatically lower than last year, but earnings should more than cover interest payments. Indeed, many credit metrics are better now than before the pandemic (see Exhibit 2).

    We expect eurozone corporate bonds to outperform US ones given the diverging monetary policies. While the market is currently pricing in various US rate rises this year, there may be at most one move by the ECB.

    We are positive on high-yield. With above-trend economic growth likely this year, the credit quality outlook is reassuring.

    Among the sectors, we are most positive on European banking given the improvement of the economic outlook and the possibility of higher rates (notably in the UK).

    Local emerging market debt – the appeal

    Since we expect US yields to rise significantly in 2022, we favour being short duration in hard currency emerging market debt. Regionally, outsized returns should be driven by Asia high-yield bonds given their attractive valuations and the scope for significant spread narrowing.

    On default rates, we believe 2022 will be a turning point. Investors should recognise Asia credit as a large and diverse asset class beyond Chinese real estate developers. We expect a significant rally.

    We see room for a marked re-allocation of assets towards under-owned local currency Chinese debt amid further policy easing while the rest of the world is in a tightening phase.

    More generally on EM, we see attractive opportunities in local currency bonds when EM currencies and rates start to rally. In addition, 2022 will be a year of innovative thinking about environmental, social and governance factors as investors start to appreciate matters ESG in emerging markets. 

    Please note that articles may contain technical language. For this reason, they may not be suitable for readers without professional investment experience. Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice. The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns. Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions). Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.

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