2022 Fixed Income Outlook

At a high level, we suggest that allocators adhere to the following guiding principles when setting out to build an AWC portfolio:

1. Identify your credit allocation’s goals:
First and foremost, we believe it’s critical at the outset to clearly and realistically define your credit allocation’s long-term goals and objectives, including total return expectations, investment risk parameters, ongoing liquidity needs, and target correlations with other asset classes.

2. Utilize all of the tools at your disposal:
We believe in drawing on a broad investment opportunity set and looking closely at a portfolio’s combined credit exposures. That means striking a balance across private credit markets and diversified public credits, as well as allocating to credit strategies with differing betas and liquidity terms in pursuit of the hoped-for risk-adjusted return outcome.

3. Be holistic, not siloed, in your approach:
Be prepared to view your credit allocation holistically, from a total risk and return perspective, versus a siloed approach that splits the allocation among multiple distinct credit “buckets.” Strategy diversification makes the whole greater than the sum of its parts and boosts the likelihood of achieving strong risk-adjusted returns across business cycles.²

Figure 1

Take the next steps

Any discussion of building an AWC portfolio must consider the proper framework within which such a strategy should be constructed, with an eye toward maximizing the potential benefits of each of its component pieces. For a deeper dive, please download the full white paper from which this excerpt was taken, A credit strategy designed for all seasons.

¹A risk premium is the investment return an asset is expected to generate in excess of the risk-free rate of return, as typically represented by US Treasury bills. | ²Diversification does not ensure a profit or guarantee against loss.

Neutral risk posture…for now

As of this writing, we maintain a neutral risk posture overall, having grown wary of some fixed income exposures in recent weeks,  particularly certain higher-yielding credit sectors. On a more upbeat note, we still believe some spread sectors can benefit from continued above-trend global growth, underpinned by healing labor markets and an improving public health backdrop.

We suspect global inflation may prove more enduring than the US Federal Reserve (Fed) and broad markets expect, even as some supply bottlenecks ease, thereby testing the Fed’s patient resolve in removing policy accommodation. Despite the planned tapering of Fed asset purchases in the months ahead, monetary policy should continue to provide an economic tailwind, likely to be augmented by additional fiscal stimulus measures (including the US infrastructure bill).

On market valuations, recent rich levels in many credit sectors could leave investors vulnerable to negative returns if markets encounter unanticipated tail risks. However, as we look across the fixed income spectrum, we still see pockets of attractive value for investors to consider, notably in some nontraditional credit sectors. Accordingly, 2022 may be a year in which bond investors need to “break with tradition” in the search for higher return potential.

Reducing risk gradually

With valuations generally being so elevated, what has kept our credit risk outlook neutral and not poor? The short answer is, ”everything else.” Our other quantitative indicators are mostly quite positive at this time: Corporate behavior generally remains conservative, global central banks supportive (despite steps toward monetary policy tightening), and market technicals strong, all of which keep us from advocating for more cautious portfolio positioning — yet anyway.

Of the indicators cited above, monetary policy (including a rising-rate outlook) appears to be the one that is closest to begin flashing a “warning signal” and thus bears close scrutiny going forward (Figure 1). In particular, the prospect of higher-than-expected, longer-lasting structural inflation suggests that major central banks may feel the need to start tightening policy sooner rather than later. A potential policy mistake in the form of tightening too soon or too quickly could prompt us to adopt a more defensive risk stance in 2022.

Another potentially potent tailwind for markets, which isn’t captured in our quantitative analysis: unprecedented amounts of fiscal stimulus. The combination of ample fiscal and monetary support has given us conviction that the global economic expansion should continue in 2022.

So with regard to fixed income risk management, why do we think investors should consider reducing risk now? Again, it comes down to rich, arguably stretched valuations. Our credit research framework tells us that it may be an opportune time to lower risk exposure, but gradually, when spreads reach levels like today’s.

Figure 1

High yield: Priced for (unattainable) perfection

One way of looking at credit valuations is relative to government bonds. For example, we like to examine the “breakeven” default rates for various high-yield bond indices. Figure 2 shows the cumulative expected default rates required over the next five years for each high-yield index to merely keep pace with US government bonds (blue bars), as compared with “worst-ever” (red) and average (yellow) historical default experiences. (The breakeven calculation is that spread earned equals default losses.)

As shown in the far-left bars, a 21% default rate would wipe out the spread earned in US high yield, versus an average realized default rate of 22%. This means that if we see an average default rate over the next five years, a risk-averse investor would be better off holding US Treasuries. In order for investors to earn a risk premium in high yield, defaults would need to register well below average. Translation: High yield appears priced for a very rosy, likely unrealistic outcome. While near-term default forecasts are indeed benign, we have less confidence in the market’s ability to predict several years out. Bank loans, conversely, look better positioned to withstand default losses. As such, we generally prefer bank loans over high yield these days.

Figure 2

Opportunities in EM sovereigns, convertibles, and RMBS

A few credit sectors stand out to us as having a higher probability of generating excess returns in 2022 (Figure 3):

• Emerging markets (EM) high-yield sovereign debt looks particularly attractive because it is one of the few sectors whose credit spreads are still trading wide to their historical median. Granted, many EM countries’ fundamentals have deteriorated somewhat as a result of increased debt burdens amid the COVID crisis. On the other hand, global institutional support has been forthcoming from the likes of the IMF and World Bank. While we do expect some idiosyncratic EM debt defaults (as always), we believe a carefully assembled basket of high-conviction issuers should serve investors well over the medium term.
• Despite concerns around lofty equity valuations, convertible bonds exhibit a trait that many other fixed income sectors lack right now: positive convexity. Sectors like high-yield bank loans have limited upside due to tight credit spreads and issuer-owned call options, which have kept a lid on prices, but they still have all the usual credit downside. Equities, by contrast, can continue to appreciate in a middle- to late-cycle economic scenario, while the convertibles themselves retain a bond “floor,” helping to mitigate potential losses. We also favor converts because they offer the opportunity to allocate to issuers that often aren’t available in other markets, particularly in the technology and biotech sectors.
• Non-agency residential mortgage-backed securities (RMBS) still appeal to us. This sector’s fundamentals should benefit from the ongoing strength of the US housing market, which continues to be buoyed by low mortgage rates and scant supply.

Figure 3

Risks that bear watching in 2022

• Chinese deleveraging: We expect to see persistent market pressure on the Chinese real estate sector as the credit turmoil associated with China’s second-largest property developer (by sales) continues to unfold. However, we view the recent steps the Chinese government has taken to “clean up” the sector as a potentially encouraging sign for the future, including measures (such as the “three red lines” policy) aimed at deleveraging to ensure sustainable longer-term growth. Near term, China’s economy and asset prices have been hit by a convergence of external and domestic shocks, some of which have to do with the country’s political calendar and its regulatory actions in 2021. Fortunately, none of these shocks seems to have derailed the development or longer-term momentum trends of the economy. We will continue to assess whether fallout from recent events threatens normalization of economic conditions over the coming months.
• Global inflation: There remains substantial uncertainty as to the likely pace and extent of global inflation, given the volatility of recent economic data releases. Our bias right now is that inflation caused by more transitory supply factors should subside somewhat in the coming months, but that some components of inflation may have more staying power than the Fed and other global central banks expect, thus testing their will and capacity to maintain accommodative monetary policies. Central bankers will continue to face the challenge of “looking through” the more transitory sources of inflation, while also trying not to lose sight of more enduring inflation drivers (e.g., wage growth and house prices).

Focus on quality but stay nimble

Reductions in fixed income portfolio risk may be warranted in the months ahead, especially if valuations remain tight or compress further. However, we also think investors should remain nimble if, for example, bouts of increased volatility lead to greater idiosyncratic dispersions or inefficiencies across fixed income markets. In this still-uncertain environment, a “barbelled” approach, consisting of larger allocations to higher-quality, liquid assets like cash and developed market government bonds, may make sense. For greater return potential, where appropriate, leaning further into those select, non-traditional sectors highlighted above may be an effective strategy in 2022.

A shrinking arsenal of policy tools

One medium-term implication of this shifting monetary policy backdrop is that global central banks seem to be losing tools and ammunition from their conventional policy tool kits.

For example, forward guidance and rhetoric, along with yield curve control (YCC) measures, are increasingly perceived as less effective and less credible than in the past and will therefore likely play a smaller role in central banks’ approach to navigating future economic cycles. Similarly, most central banks now recognize that quantitative easing (QE) can help combat bouts of market turmoil, but is not a suitable means of generating sustainable inflation in line with policy targets. Consequently, the risk central banks now face is that if they prematurely tighten monetary policy, they will have even fewer tools at their disposal to adapt to fluid economic and market conditions.

In general, we still think the potential costs of policymakers being “early and wrong” in their actions are greater than being “late and wrong.” In addition, today’s market dynamics have resurfaced the age-old question of whether monetary policy tightening is even the best way to manage higher inflation driven by supply shortages. And could rising prices themselves lay the groundwork for a weaker cycle by blunting consumer demand for goods and services?

Major central banks roundup

Global markets and policymakers alike are coalescing around the view that global inflation will likely remain elevated for the foreseeable future (“persistent,” not “transient” as previously hoped). However, the major DM central banks’ policy responses thus far have varied somewhat:

• The US Fed has pushed back against calls for a more rapid tapering process for its large-scale asset purchase program, as well as against the idea of beginning to hike interest rates sooner rather than later. However, Fed Chair Powell is keeping the Fed’s policy options open with regard to both the speed of tapering and the timing of rate hikes.
• The Reserve Bank of Australia (RBA) has decided to abandon or at least alter its yield curve control (YCC) target.
• In an attempt to allay markets, the European Central Bank (ECB) recently delivered a dovish “pushback” message to markets, albeit with only moderate success to date.
• The Bank of England (BOE) plans to embark on a rate-hiking cycle only after assessing the impact of the British government’s pandemic jobs support plan.
• The Bank of Japan and the Swiss National Bank have been laggards in market pricing of their rate-hiking intentions. Most other G10 banks are expected to start hiking by 2022.

As of this writing, our baseline “taper path” for the US Fed is that it will likely complete the winding down of its asset purchase program by around June 2022. The Fed has retained the option of adopting a faster pace of tapering if warranted, any further indication of which in the months ahead would validate the market’s latest forward-pricing expectations. (Currently, markets expect Fed rate hikes to begin next summer, followed by the next rate increase in November). The Fed has indicated its preference for a time gap between the end of tapering and its first rate hike, but again, flexibility is the watchword here. Should the recent acceleration in wage pressures prove to be “sticky,” for example, the Fed might have to change course.

At this juncture, we anticipate a modestly dovish outcome for the BOE’s policy trajectory. The BOE surprised markets recently by choosing not to raise interest rates, citing job market uncertainty and other factors. It also acknowledged that its ability to loosen policy in response to any future negative demand shocks will be hemmed in by the lower bound on rates, implying a “go gradual” approach to normalization.

Despite the fate of the RBA’s YCC target (see above), we think the market’s hawkish policy expectations, now priced into the front end of Australia’s yield curve, are slightly overdone. We maintain a favorable bias toward select Asia-Pacific duration markets, including Australia’s.

Fiscal to the fore

Front-end yield curve markets have been testing global central banks’ patience and resolve. Longer-dated sovereigns have reacted via curve flattening, suggesting a greater chance of a policy error (e.g., tightening policy too early). This has been particularly evident in the UK and US fixed income markets. Much of the recent change in front-end pricing appears to have brought the timing of rate hikes forward as opposed to extending hiking cycles. Hence, we think fiscal policy will begin to replace monetary policy as the main influence on market direction.

If the US human and physical infrastructure bills pass, markets can then put a higher probability on increased government investment in the coming years. This would be a potent catalyst to (at least in the short term) break the substantial US yield curve flattening trend of recent months. Meanwhile, the European and UK fiscal pictures both point to the likelihood of high (and potentially rising) spending outlays in the period ahead — in contrast to the US, which could be in stalemate over additional government spending post the 2022 midterm elections.

Globally, growing appetites for climate-related investment needs and increased sociopolitical preferences for higher budget deficits suggest a more activist fiscal stance relative to monetary policy over the next few years.

Emerging markets and the China factor

Emerging markets (EM) central banks have taken a markedly different policy approach from that of their DM counterparts, “front-loading” rate hikes in an effort to counter inflationary pressures. This hiking cycle has been driven by a need to anchor inflation expectations and to avoid currency depreciation and related instability, which have been a headwind for many local rates but have also created pockets of value in select EM assets. We continue to believe Chinese local rates are attractive, given their potential diversification benefit from historically low correlations to other sovereign debt markets. Moreover, China’s economic and policy cycle is in a different phase than other EMs, with output now slowing and the People’ Bank of China (PBOC) likely to pursue easier monetary policy, with an eye toward loosening financial conditions, going forward.

On China’s economy, we think further growth downside is limited, provided the PBOC’s overall policy tone remains accommodative. The two obvious wildcards that could jeopardize this usual two-step of “policy looser, growth stronger” would be a structural deterioration of home-buyer sentiment and a further acceleration in inflation. However, the apparent lack of transmission from sluggish real activity in China to softer commodity pricing is a distinguishing feature of this current cycle, as is the absence of feedthrough to growth in the rest of the Asia-Pacific region.

Global inflation: The new bogeyman?

Global inflation dynamics are undeniably changing, and most likely not for the better. At last check, inflation was already registering above its pre-pandemic peak (Figure 2), despite lower levels of economic growth, in both EMs and DMs. This is partly due to temporary phenomena — chiefly the so-called “bottlenecks” associated with COVID-induced supply-chain disruptions — but it also seems to reflect a structural shift to persistently higher rates of global inflation henceforth. What’s driving it? A number of the key factors that dampened inflation over the past 30 years are now in reverse and have largely given way to other global forces with more long-term inflationary effects: deglobalization, localization of supply chains, labor shortages triggered by COVID, and evolving consumer preferences and habits, among others.

Figure 2

The next six months could be characterized by rocky, uneven growth patches. Nevertheless, at a high level, we still think the most likely endgame for the global cycle that is now underway should be one of reflation rather than the much-feared “stagflation” scenario, as many consumers spend down the savings they accumulated during the pandemic, corporations increase capital expenditures (capex), and government policy — particularly fiscal — remains supportive. We believe the greater risk is that of recession rather than stagflation if, for example, inflation squeezed real wages and turned the cycle over, global COVID cases resurged, central bankers prematurely tightened policy, and/or China’s slowdown worsened.

In any event, what is clear is that rising global inflation is leading central bankers worldwide to reassess the risk/reward trade-off of letting their economies “run hot” or for too long. Accordingly, investors should no longer assume that flagging economic growth will always result in ever-more policy-driven liquidity courtesy of central banks. With that in mind, a pivotal (and as-yet unanswered) macro question is whether labor market dynamics have changed sufficiently to allow workers to be compensated for higher inflation through higher wages. If so, then inflation is likely to have legs and monetary policy to tighten sooner and by more than markets expect. If not, then the cycle would likely sour, as consumers’ purchasing power gets increasingly pinched.

US inflation, productivity, and wages

In the US, our current bias is toward higher unit labor costs and more enduring inflation relative to the Fed’s and market’s expectations. Pipeline cost pressures, supply bottlenecks, and retail price intentions would suggest that goods inflation stays elevated, before waning over the next 12 months. At the same time, we think core services inflation, which is more sensitive to the domestic output gap and labor markets, will start to pick up. If our leads are right, all of which imply upside risks to the Fed’s 2022 inflation forecasts, we suspect the Fed would start to more seriously question the dubious “transitory narrative,” especially given some improvement in the labor market. We will be closely monitoring the details of capex and of prospective fiscal policy for anything that might challenge our thinking.

The Fed seems pretty upbeat about US productivity growth rising in the context of potentially higher labor market participation rates. This attitude underpins the Fed’s belief that: 1) longer-term inflation will likely settle back around 2.0% over time; and 2) there remains excess capacity in the domestic labor market. While recent productivity, wage, and inflation data don’t necessarily support that, we think the Fed’s optimism is still justified given today’s labor shortages, US demographics, and other factors. It would likely take time for the Fed to meaningfully revise its view on structural productivity trends.

Commodity prices and decarbonization

Commodity prices will be critical to both the global and US inflation outlooks. A potential change in OPEC+’s reaction function (including a marginally greater tolerance for higher oil prices) and/or US shale discipline preventing a proportional increase in US oil production could continue to push oil prices upward in 2022.

Broadly speaking, ongoing decarbonization will likely restrain global growth to some degree, at least until countries can map out viable longer-term energy transition plans, including a “bridge” of sorts (i.e., natural gas) between fossil fuels and renewable energy. In the interim, commodity price pressures are showing signs of impacting the “economic reopening-linked” demand and growth recovery. But the US consumer has rarely been healthier, with the low-wage cohort in particular stepping up its spending in an environment of significant labor shortages and widely understated wage gains. The US economy seems better placed to weather the latest energy “storm” than DM energy importers like Japan, the UK, and the eurozone. In addition, US trade exposure to China looks negligible when compared to that of Australia, New Zealand, and Japan.

Key takeaways

• Global markets are less likely to perceive monetary policymakers as reliable forecasters or drivers of economies and business cycles. DM central banks may struggle to achieve dovish, market-friendly outcomes relative to the market’s more hawkish expectations these days. 
• Rather than extending rate-hiking cycles, markets are “pulling forward” the timing of rate hikes amid worries over rising inflation and slowing economic growth, which have eroded markets’ confidence in the longer-term macro outlook.
• Global trade wars and the COVID pandemic have reshaped the nature of inflation risk, with secular themes of deglobalization and localization of supply chains incenting firms to hold higher amounts of inventory going forward.
• Central bankers face a delicate balancing act: Is monetary policy tightening supposed to help rein in higher consumer prices, OR will accelerating inflation itself set the stage for a weaker cycle? DM and EM policy responses to this dilemma have differed.
• The inexorable trend toward decarbonization will likely temper global growth to some degree, at least until more countries can map out viable longer-term energy transition plans.
• We currently favor underweight duration biases in the US, the UK, and Europe, versus moderate overweight biases in Asia-Pacific, including South Korea, Australia, and China.