Will 2023 be the turning point for long-suffering bond investors? Will bond markets come alive again after struggling to deliver yield for so many years? Will central banks reverse the upwards trajectory of interest rates, boosting the attractiveness of fixed-income securities?
These are some of the questions we ask ourselves as we prepare to bid farewell to an awful year for financial markets. In fact, 2022 is on track to become the worst year for bond performance in recent memory – a record that we don’t want to see again.
That said, these questions aren’t just wishful thinking on our part. We think the signs are there for a reversal of fortune for bonds that could be as dramatic, if not more so, than what we’ve had to endure so far.
The story so far...
Many people know that inflation is a bond investor’s ‘kryptonite’ (the fictional material that is Superman’s Achilles’ heel).
Not only does inflation eat away at the coupon a bond pays, but it usually triggers a monetary response from central banks in the form of higher interest rates. If interest rates (and bond yields) rise, bond prices will fall.
When Russia’s invasion of Ukraine earlier this year disrupted energy and food supplies to the rest of the world, compounding supply problems linked to Covid lockdowns, it unleashed the sort of inflation that most of us haven’t seen in decades.
Central banks in many jurisdictions were forced to raise interest rates to stop prices from spiraling out of control.
Policymakers have pledged to continue raising rates into next year, even if it means pushing economies into recession.
Bad for bonds
In theory, bonds ought to perform well during periods of rising risk – slower economic growth, war, general uncertainty – serving as a defensive asset within a portfolio.
However, in practice, bond performance disappointed this year, especially when compared to riskier asset classes such as equities. This was extraordinary, given how expensive equities were – particularly for a number of pandemic-related and technology stocks.
There were good reasons for this. One reason is that company revenues are nominal (firms can raise prices). Therefore, shares implicitly have some level of inflation protection embedded within them.
On the other hand, bonds pay a fixed nominal coupon which inflation erodes to leave investors with a much lower real return.
Furthermore, bond yields were so low at the start of this year that the average bond duration – the period of time before they mature – was very high, as investors sought marginally better returns in longer-dated paper.
Therefore, bonds were expensive, with the effect that the subsequent fall in bond prices, for a given rise in yields, was also very steep.
Why we dare to be optimistic
Things have looked grim for the bond markets, but here are three reasons why we think we may have reached a turning point:
- Recession to bring inflation under control. Global economic activity will slow next year as high food and energy prices combine with high interest rates (and eventually job losses) to lead to recession.
As an economy weakens, and unemployment rises, we expect inflation to fall. When you start off with high global commodity and goods prices as a result of pandemic-related distortions, you have the potential for large declines in inflation.
Current market pricing suggests the US Consumer Price Index (CPI) will fall to around 3.5% by December 2023, down from some 8% now. Similar dynamics are now priced into most major markets. - Central banks to stop monetary tightening. Recession, plus a some five-percentage-point decline in headline inflation, will give room to central banks to ease up on, and start reversing, interest-rate hikes.
If this economic scenario plays out then the policy hawkishness we see today – monetary tightening – will start to evolve next year into a more cautious stance and then, ultimately, we could expect significant interest-rate cuts.
Lower interest rates may not materialize until late 2023, or even early 2024, but financial markets are forward-looking. Investors will price those cuts well in advance of central-bank confirmation. This is an environment that’s far more conducive for bonds. - Relative valuations - bonds vs equities. After a year of market turmoil, bonds haven’t been this cheap, relative to equities, since the peak of dotcom mania in the late 1990s and early 2000s.
Equities have scope to fall further. If history is any guide, the maximum drawdown for stocks, relative to bonds, from this sort of relative valuation comparison could range from 25% to 75%.
Previous periods when bond valuations, versus equities, were this attractive came usually at the top of equity bull markets.
The exception was in 1981 when it was very much a story of how cheap bonds were in absolute terms, after US Federal Reserve Chairman Paul Volcker helped drive interest rates as high as 20%.
The current situation probably sits somewhere in the middle. Equities are still quite expensive, while bonds are quite cheap. Long-term investors and asset allocators should begin to see this and respond as we move into 2023.
Valuations - Bonds cheap vs equities
Source: Absolute Strategy Research, Bloomberg, October 2022
Final thoughts
If we’re right about how 2023 pans out, we will likely see weakening economic growth, falling inflation and revised central bank policies that are more supportive of financial assets.
Investors will anticipate this change in market dynamics and start redirecting assets out of cyclical (and expensive) equities into defensive (and cheap) bonds.
In the event that all these conditions are met, they should add up to a much more positive year for bond investors everywhere.
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