- Inflation expectations remain front and center for investors as price surges persist longer than many expected, raising concerns about the impact on fixed income asset classes. We continue to believe sustained higher inflation is unlikely and that much of the price increases we’re experiencing are still primarily attributable to reemerging demand and supply chain bottlenecks that will ultimately resolve toward the end of 2022.
- While yield curves have lifted from a secular bottom, the magnitude of any future upturns will not be material; we expect interest rates to remain persistently lower in the “Next Normal,” with a continuation of negative real policy rates. In this environment, investors will continue to reach for yield but under broadly accommodative market conditions.
- Against this backdrop, we remain most constructive on leveraged finance assets in 2022, including bank loans and high yield bonds, as well as small and medium enterprise (SME) private credit. Collateralized loan obligations (CLOs), and the incremental complexity yield premium they bring, are also highly attractive in a near-zero default environment.
- Despite China’s property sector woes, we believe emerging markets (EM) continue to offer attractive opportunities and that investors may benefit from a selective approach as quality names get caught up in negative headlines.
- We’re also constructive on investment grade credit relative to government bonds, with attractive all-in yields, net leverage now below pre-Covid levels, and upgrades expected to far outpace downgrades in 2022. But with expectations for short-term periods of volatility during the transition, we believe it’s prudent to have some dry powder on hand in the form of high-quality short-duration securities to act during periods of weakness.
Fixed income investors continue to balance the shifting tailwinds from supportive macro fundamentals and improving corporate earnings potential with prospects for slowing growth, higher inflation, and less accommodative monetary policy as we head into 2022.
Robust demand for yield and hence credit has resulted in the easy absorption of a record supply of new issuance. Yet the late-cycle valuations are well supported by plunging default rates and improved underlying leverage metrics. As we transition toward a post-Covid world and the distortions arising from it, 2022 represents the path to normalization with respect to fiscal and monetary policies, economic trends, and, across society, the “Next Normal.”
Since the global financial crisis (GFC), central bank monetary policy has arguably been the dominant influence on global financial markets, and 2022 represents a potential transition in policy toward the Next Normal equilibrium. The Federal Reserve has commenced its taper of purchases and issued guidance toward a steady pace of $15 billion per month before exiting in June 2022. Other central banks are also seeking to exit extraordinary measures enacted during the Covid crisis, but their pace and approach will differ. What is less certain with respect to the Fed is the timing and pace of policy rate increases, with the market pricing in two hikes in 2022, and even more surprisingly, pricing in a hike by the European Central Bank (ECB) as well. Surging inflation has reignited the debate on (and definitions of) transitory and secular increases. On the flip side, China’s policy pivot and the shift away from globalization are indications of slowing global growth.
While yield curves have lifted from a secular bottom, the magnitude of any future upturns will not be materially higher; we expect interest rates to remain persistently low in the Next Normal, with a continuation of negative real policy rates. In this environment, investors will continue to reach for yield but under broadly accommodative market conditions.
Against this backdrop, for 2022, we remain most constructive on leveraged finance assets, including bank loans and high yield bonds, as well as small and medium enterprise (SME) private credit. Collateralized loan obligations (CLOs), and the incremental complexity yield premium they bring, are also highly attractive in a near-zero default environment. Despite China’s property sector woes, we believe emerging markets (EM) continue to offer attractive opportunities and that investors may benefit from a selective approach as quality names get caught up in negative headlines.
We’re also constructive on investment grade credit, with attractive all-in yields, net leverage now below pre-Covid levels, and upgrades expected to far outpace downgrades in 2022. But with expectations for short-term periods of volatility during the transition, we believe it’s prudent to have some dry powder on hand in the form of high-quality short-duration securities to act during periods of weakness.
Whither inflation?
Inflation expectations are still front and center for investors amid price surges that will persist longer than many expected, raising concerns about the impact on fixed income asset classes. Despite these worries, we continue to believe that sustained higher inflation is highly unlikely in the Next Normal and that much of the price increases we’re experiencing are still primarily attributable to reemerging demand and supply chain bottlenecks that will ultimately resolve toward the end of 2022. However, the stair-step in a large portion of the current rise will not reverse and may reset at the higher levels – this means inflation could be marginally higher relative to prior trends due to several longer-lasting factors.
Much of the demand tailwind arising from government stimulus will wane, given that these efforts have been primarily focused on one-time income replacement and demand generation. And while additional stimulus measures, such as infrastructure spending in the US, are in the offing, we believe their impact on sustainable inflation will be limited. That said, we do expect a more permanent policy shift in favor of fiscal stimulus and a greater willingness from governments globally to run budget deficits, particularly given the low cost of funding and populist support.
Looking over the longer term, the question becomes, what structural factors have led, pre-pandemic, to the ongoing secular decline in inflation, and will they change? When we consider what has caused inflation to remain low over the past several decades, it boils down to three primary drivers: 1) demographic trends, including an aging population and declining birth rates, particularly in the developed markets; 2) the impact of technological advancements; and 3) a global savings glut.
Looking out over the next decade, we expect these core trends to persist. So what is different? We see three factors that will incrementally push inflation higher: 1) lower and negative real policy rates; 2) the aforementioned greater fiscal stimulus, particularly focused on social equity; and 3) the adoption and implementation of environmental, social, and governance (ESG) improvement initiatives.
While we expect to see a somewhat higher level of inflation in the Next Normal after transitory factors fade toward the end of 2022, inflation will not be persistently high as we reset toward pre-Covid trend-plus levels.
Gauging a ‘normalized’ yield curve
What are the implications of these developments for yield curves and government bonds? In the short term, we expect yields to remain range-bound, with a skew toward higher yields at the back end of the curve – but only marginally, given the Fed’s tapering path and its march toward normalized policy rates anchored at very low levels. The front end is already pricing in a much more aggressive stance for 2022, and we believe a more dovish outcome will be the result.
Over the intermediate to longer term, the question becomes what the Next Normal’s “normalized” yield curve will look like, which begins by setting our expectation for a “neutral” policy rate. We believe that in the US, the Fed will ultimately reach a neutral policy rate in the low 1% area, and the resulting impact will be negative real policy rates for the foreseeable future. This is in contrast to the Fed’s dot-plot forecasts, which indicate a 2.5% rate. Similarly, the ECB has been mired in negative interest rates for a while, and we don’t expect policy rates to breach zero for some time; but ultimately, a neutral rate goal will be to achieve positive nominal rates.
With a positively sloped yield curve overall but lower term premiums relative to historical levels, and with the policy rate setting the short end of the curve, we expect a fairly low (1.5%-2.0%) range at the 10-year end of the curve for US Treasuries – much lower than historical levels, but somewhat higher than what we’ve seen during the crisis period of the past 18 months. While there is concern that US interest rates could rise substantially above that range, we think it’s important to remember that global rates are highly interconnected: US Treasuries cannot persistently rise materially above German bunds or other key rates on a foreign exchange (FX) hedged basis. That dynamic will limit and anchor US Treasury rates despite stronger growth expectations relative to many other developed nations.
Valuations and the risk premia reset
As discussed in our 2021 midyear outlook, fundamentals are still showing largely early-cycle characteristics in the rebound following the Covid-prompted short-but-sharp recession and spike in defaults during 2020 towards a near-zero default environment in 2021 and remaining ultra-low in 2022. Credit mini-cycles are becoming more frequent, within elongated credit default cycles. While we’re now heading toward mid-cycle in 2022, we expect continued tailwinds and solid growth in corporate earnings, but at a slowing pace and with wider dispersion as cost pressures filter into margin compression for certain segments.
Overall, these conditions are supportive of credit spreads for the foreseeable future, but current late-cycle valuations have minimal room for price appreciation, capping return potential to coupon yields. One of the few areas where we see outsized return opportunities (amid high risks) is within Asia corporate credit, and particularly within the Chinese property segment. Fear and dislocation have historically been the source of the best investment opportunities for those who can effectively filter through the trauma.
Yet one factor that we believe must be taken into account is that historical risk premia for all assets are in need of a readjustment given central bank supported market conditions over the next five to ten years. In addition to the negative real policy rate environment, central banks, and the Fed in particular, have shown their willingness to forcefully jump into financial markets at the first sign of an exogenous shock or recessionary environment – which essentially truncates the most severe, left-tail risks.
Taken together, these factors indicate that historical risk premia for risk assets more broadly are no longer appropriate, and that current tight valuations are not necessarily overvaluations – rather, they fall within the range of fair value when adjusted to reflect Next Normal risk premia.
Opportunities in the new year: the right risks at the right price
Given our view that early- to mid-cycle fundamentals still predominate, investors are operating in an environment of excess yield return opportunities supported by low default rates and improving corporate earnings trends. While potential fallout from China’s evolving property sector has thrown a wrench into default forecasts for China and for emerging markets more broadly, we have noted minimal contagion thus far in the broader EM indices and attractive opportunities emerging amidst the rubble.
Against this backdrop, we favor taking on additional credit risk exposure relative to government bonds, particularly leveraged finance credit in the form of bank loans as well their hybrid, CLOs, along with high yield bonds. Investors also are turning to private debt markets, which offer incremental yield from illiquidity and small-company premiums.
Amid a broadly improving global outlook, we see attractive valuation opportunities in targeted geographic risk premia in emerging markets. We are more constructive generally on corporate credit in EM, with supportive fundamentals, but see pockets of opportunities in local currency. But the big question in EM, of course, is the impact of developments in China, including the ongoing property segment saga and the country’s recent policy pivot.
Thus far China’s credit market volatility has not shown evidence of widespread contagion in EM, although default forecasts are rising for weaker participants in property and related sectors as external liquidity access evaporates. We believe these and other corporate credit stories are idiosyncratic in nature and do not yet pose systemic risks. If headline events lead to more broad-based spread widening, this may create opportunities to invest in companies caught up in the risk-off sentiment.
We expect the evaluation of ESG risks, while critical across fixed income, to take on an increasingly important role in identifying EM securities that will outperform in a market where traditional credit risk appears fairly valued. As noted in a recent blog post, we believe comprehensive integration of ESG into investment research can add alpha by seeking out issuers who are actively committed to improving their operations’ sustainability and, therefore, their ESG risk ratings.
Higher ESG Ratings Have Translated to Outperformance
ESG rating relative to credit rating and 2021 total return (YTD as of 20 October 2021)
Amid continued broadly low return expectations and the quick shifts in fixed income markets of late, we believe it’s critical to look within asset classes that offer compelling alpha potential and to capture those opportunities when they present themselves. This means taking a flexible, opportunistic approach to incrementally capture relative value, not only across asset classes and geographies, but also with specific securities.
While lower return expectations create a challenging environment heading into 2022, it is also a lower-risk environment for many areas of fixed income. The key will be identifying and pricing those risks, and managing them consistently to produce favorable investment outcomes.
For more economic and asset class insights, see our full 2022 Investment Outlook: Opportunities in a Climate of Change.