Rate reset may fuel a new bond bull market
Aggressive central bank rate hikes and the resulting bond bear market in 2022 were extremely painful for investors. With 2023’s banking crisis adding to a backdrop already at risk from the hikes, economies must now cope with the frictions and long tail of the crisis. We see a material slowdown in GDP growth in major western economies. In light of the recent shocks and the Fed’s constrained ability to contain a broader crisis, our base case calls for “weakflation,” i.e., weak growth and inflation of more than 2%, but falling. We’ve also significantly reduced the odds of a recession given the ongoing strength in the labor market.
Consistent with these adjustments, the shock has reduced the likelihood of a soft landing (moderate growth and inflation) or a roaring 2020s scenario (high growth and low inflation). Our base case for the Eurozone also calls for a weakflation scenario. By contrast, China’s growth should reaccelerate this year.
Inflation Falling in U.S., Remains Sticky in Europe
Inflation is starting to fall from high levels, notably in the U.S., led by core goods and to a lesser extent services. Eurozone inflation is proving more sticky, due to the indirect effects of energy prices and more acute supply-chain disruptions.
Current Conditions May Force a Fed Pause
Before the banking crisis, reducing inflation was the top priority of central bankers. Now they may be more balanced in their efforts to tamp down inflation given their newfound appreciation for unforeseen risks.
While moderating inflation also gives central banks some breathing space, diverging economic data are leading to diverging expectations for central bank rates. The Fed has a better chance of downshifting compared to the ECB and has already signaled a rate-hike pause. The key question is when and for how long. Inverted yield curves are indicating recessions in 2023. With the already-brewing credit crunch likely to contract the U.S. economy in the second half of the year, we expect the Fed to deliver one more hike before sitting on the sidelines for the rest of the year.
Despite the difficult path markets have taken, there are periods when negative developments can be market positive. For instance, there has historically been a narrow window between a Fed tightening cycle ending and an easing cycle beginning, with nine months as the average time between the two based on the past four rate hike cycles. The 12 months after rate hike cycles ended have been beneficial to fixed income investors, broadly speaking.
Early Innings of a New Bond Bull Market
The cumulative impact of higher rates and mounting risks are negatives for growth; but once yields reach elevated levels and the economy begins to slow, bonds can be quite attractive. We are firm believers that the game is still on for bonds and that we are in the early innings of a new bond bull market. After a year where bonds struggled to provide the ballast in portfolios that investors desperately needed during high equity volatility, we expect bonds—due to their higher yield configurations—will again provide supportive ballast as market volatility continues. We believe the next phase of the cycle will be an optimal period for investors to identify opportunities to generate alpha.
Secular Trends Signal Long-Term Move Back to Lower Rates
The current macroeconomic backdrop likely will revert to pre-COVID-19 conditions over the longer term. Secular factors—such as aging global demographics, high debt levels and deleveraging, and mounting geopolitical competition—are likely to lead us back to subdued growth, moderate inflation, and lower central bank policy rates.
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