Within high-quality rates, we favor US rates and investment-grade corporates relative to European government bonds and we are neutral on Japanese government bonds (JGBs). While the Fed is the most hawkish developed market central bank, we think markets have adequately priced policy. We see more pain in Europe, where the 10-year bund yield is around 1.10%, inflation is very high at 8.1% as of May, and the ECB is getting more hawkish. In Japan, inflation, at around 2.5%, is just above the central bank’s long-awaited target. Even if the bands for 10-year JGBs are widened due to concerns about higher inflation, we think the upside risk for yields is limited.
As of May 31, US corporate bonds were offering a yield of 4.2%, so we believe allocators will covet steady coupons compounding at higher-than-median spreads. In our view, riskier credit is vulnerable to spread widening in a slowing economy.
While recession is not our base case, the probability has risen. Recession is the downside case where tighter fiscal and monetary policy aimed at reversing the inflation impulse has a high potential for policy errors.
Central bank tightening is starting to impact the most rate-sensitive sectors, such as housing, and consumer confidence continues to weaken. Meanwhile, the prolonged period of low rates and excess liquidity has likely led to a misallocation of capital in some areas, which may be exposed as air pockets in liquidity are revealed. These could lead to accidents, or market failures, as in past periods of reduced liquidity.
Another downside risk is an escalation in the Russia/Ukraine conflict that forces Europe into a full phase-out of Russian gas (not just oil). Finally, global uncertainty has begun to weigh on the earnings outlook, with company profit warnings precipitating sharp sell-offs, and earnings expectations have room for further downward adjustment.
A soft-landing scenario with inflation moderating without a hit to growth is not our base case, but it is an upside risk. In the US, there are some indications of a potential peak in inflation, including in goods inflation — e.g., the inventory/sales ratio appears to have bottomed. While services inflation has been strong due to reopening pressures, early signs of a slowdown in the housing market will feed through to shelter inflation.
China is implementing a number of easing policies to counter a contraction in its economy and some senior officials are pushing for more. However, zero-COVID policies could stymie the effective transmission of stimulus measures.
While the fiscal impulse is negative in most regions relative to COVID-era largesse, fiscal policy remains expansionary in the European Union and the UK, due to the long tail of prior programs and to subsidies aimed at mitigating the impact of cost-of-living increases. Further fiscal easing in the second half of the year is an upside risk, particularly in China and Europe, and could partly offset the global growth slowdown.
Tilting toward quality — We expect the global cycle to slow, with liquidity being drained from the financial system, and therefore prefer a moderate underweight to equities and a tilt toward quality as opposed to any particular sector. We think companies with pricing power, long-term margin stability, and healthy balance sheets will be more attractive amid continued supply-chain disruptions, cost pressures, and volatility.
Sticking with fixed income amid higher volatility — From a yield perspective, we think US rates and investment-grade corporates stack up well to equities. At current valuations, high-quality fixed income has the potential to dampen portfolio volatility and provide some protection against further equity sell-offs as the global cycle softens.
Continuing to seek inflation protection — There is no sign that commodities companies are planning to ramp up capital spending and production. Thus, we see a continued supply/demand imbalance that could keep commodities prices elevated structurally and argue for commodities equities, inflation-protected bonds, and some real assets.
Approaching credit allocations judiciously — We think spread widening has further to go in high-yield assets if, as we expect, the economy slows over the next 6 – 12 months. That said, we see select opportunities in convertibles, structured credit, short-duration credit, and housing-related assets.