Fixed income has surprised many investors this year by not only producing negative returns alongside equities, but in some cases even underperforming equities. After the worst start to the year in history, many investors are shunning the asset class, but we believe that’s a mistake. When it comes to understanding the landscape and potential opportunity in bonds, we need to ask ourselves three questions.
Question 1: “Do we believe that the policies put into place during COVID-19 have created a new paradigm or structural changes within the global economies?”
No. We don’t believe that the majority of the global economy has been structurally impacted by pandemic policies. While there’ll be some changes as a result of deglobalization, we don’t believe COVID-19 has caused the end of globalization completely.
Two areas that have garnered a lot of attention are supply chains and employment. Regarding supply chains, we’re seeing early signs of normalization back to pre-pandemic levels. The PMI Suppliers’ Delivery Times Index is a widely used indicator of supply delays, capacity constraints, and prices pressures and it’s indicating that delivery times are improving in the United States, Europe, and Asia. Many companies around the world are also looking at ways to improve their supply chains, through diversification of suppliers, nearshoring, or other strategies, which could improve efficiencies longer term.
The tight labour market and government policies to increase minimum wage, predominantly in the U.S., has resulted in material wage growth. As the global economy slows further, this is likely to alleviate some of the supply and demand imbalances in the labour market, which could lead to, at minimum, a slower trajectory in wage growth.
Inflation averaged 1.7% in the 10 years prior to March 2020. Structural factors including demographics, productivity, and technology were some of the causes of that lower inflation. These structural factors have led to declining inflation levels over the past couple of decades, as illustrated below.
We don’t believe that policies related to COVID-19 have changed those structural factors; in fact, we’ve grown older and added to our debt levels. In response to COVID-19, the global economy added to its debt levels—in 2022, the U.S. added roughly $2.2 trillion through the CARES Act alone. And debt, by its nature, is deflationary. The interest cost to service that debt makes that debt more expensive than the original loan value, especially during periods of rising rates. Ask anyone with a variable-rate mortgage whether they plan on spending more or the same due to increases in interest rates this year. I think we know the answer.
Question 2: “Do we believe that higher interest rates can result in lower inflation?”
Yes. While inflation has remained sticky and higher than many would have expected, we believe there are plenty of signs that indicate that higher interest rates are having a positive impact on inflation. We have already seen an increase of 3% in the U.S. Federal Reserve funds rate this year, which is by far the most aggressive tightening cycle in over 40 years. The market currently expects another 1.25% through the end of this year. It can often take 12 months or more for changes in central bank interest rates to have an effect on the economy and inflation. A slowing global economy is likely going to help central banks bring down inflation from current lofty levels.
In our view, there’s now much more certainty around Fed policy and inflation than at any point in 2022. We believe that the Fed is nearing the end of its tightening cycle, and we’re already seeing signs of inflation coming down in the form of the Commodity Research Bureau Index, NFIB Small Business Survey raising prices, and ISM Manufacturing Prices Paid Index.
Question 3: “Do we believe that the odds of a recession have increased?”
Yes. We’re seeing evidence already of a material slowdown in economic growth as indicated by current levels of Global Purchasing Manager Indices, U.S. Leading Economic Indicators (LEIs), and much tighter financial conditions. The U.S. LEIs posted –1 for the month of August—typically, when this measure becomes negative, a recession happens six months afterwards, on average. The U.S. 10-2-year spread has been negative for three consecutive months, historically, a very good indicator that a recession will occur within the next year, on average.
But bonds have provided negative returns year to date!
That’s true, the FTSE Canada Universe Bond Index, Bloomberg US Aggregate Bond Index, and Bloomberg Global-Aggregate Bond Index are down –12%, –15%, and –20% year to date, respectively. Bonds didn’t behave in their typical fashion during any of the market volatility this year; in fact, they were often the cause of the volatility as yields across the curve spiked. Equity market volatility is much more common and better understood by investors, but most are not used to seeing negative returns from their bond funds. This has resulted in many difficult conversations, especially as bonds aren’t the easiest asset class to understand.
Perhaps it’s a good idea to re-educate ourselves on the traditional role of bonds: 1. income, and 2. capital preservation when equities sell off.
Over the last 30 years or so, bonds have fulfilled their dual duty within a balanced portfolio for the most part. The unprecedented policy response by governments and central banks and supply chain disruptions brought on by the COVID-19 pandemic, combined with soaring energy and food costs as a result of the Russia-Ukraine conflict, has been the perfect storm, leading to inflation levels not seen in decades.
However, that’s in the past and we need to look forward.
So … why bonds now?
From an asset allocation perspective, it’s an environment to get excited about. We believe that bonds will revert to their traditional place in a portfolio. If the central banks are nearing an end to their tightening policy, the worst for bonds is likely behind us.
High-quality investment-grade sovereigns and credits yields are at levels that would’ve been unthinkable several years ago. The search for yield from only a few years ago, is no longer an issue and investors no longer need to increase their risk level to achieve it.
In addition to higher levels of current income, if we’re headed into a recession and bonds react as they’ve often done during past recessions, longer-duration government bonds have the potential to provide upside total return. We need to remember that as bond yields fall, prices tend to rise, and vice versa. The headwinds that we faced for much of this year when yields were rising could turn into tailwinds as yields fall.
A rise in interest rates typically causes bond prices to fall. The longer the average maturity of the bonds held by a fund, the more sensitive a fund is likely to be to interest-rate changes. The yield earned by a fund will vary with changes in interest rates.
Currency risk is the risk that fluctuations in exchange rates may adversely affect the value of a fund’s investments.
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