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2023 Bond Market Outlook

2023 Macro and rates outlook: Goodbye easy money, hello regime change

John Butler, Macro Strategist
2023-12-31
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The views expressed are those of the author at the time of writing. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional, institutional, or accredited investors only.

This is an excerpt from our 2023 Investment Outlook, in which specialists from across our investment platform share insights on the economic and market forces that we expect to influence portfolios in the year to come. This is a chapter in the Bond Market Outlook section.

The macroeconomic environment that has underpinned the global financial markets for the past 25 years is clearly transforming, with potentially profound implications for how investors should think about asset prices and market structures. Indeed, we believe this reshaping of the macro landscape — nothing short of "regime change" — is likely to challenge (and maybe even overturn) many of today's long-held investment assumptions.

Nowhere is this more true than on the global inflation and interest-rate fronts. The so-called "easy money" era — a multi-decade period marked by historically low inflation and ultra-accommodative monetary policy — is over.

New reality: Structurally higher and more volatile inflation

Structural global inflation is at the root of our "regime change" thesis. In fact, we have been steadfast in that conviction for more than a year now, even as the market and central bank consensus was suggesting that resurgent inflation was merely "transitory." Our 2021 research concluded that going forward, inflation was likely to be stubbornly higher and significantly more volatile than expected. Some, though not all, of the longtime catalysts of low and stable inflation are now more or less in reversal. Namely, we are seeing tectonic shifts toward less globalization, greater regionalization, and a new set of political objectives (including decarbonization) that will require more activist fiscal policy — policies that we believe are more apt to generate higher inflation than stronger trend growth. 

Broadly speaking, the global macro environment from here is likely to be somewhat reminiscent of that in which the capital markets operated pre-1995 (rather than post-1995). A striking feature of much of the past 25 years is how tame macroeconomic volatility has generally been, in terms of both GDP growth and inflation, despite some major recessions along the way (Figure 1). We think we are returning to a world where GDP growth and inflation are going to be more volatile, similar to what we experienced from the mid-1960s to the late-1980s. During that period, economic and business cycles tended to be more frequent and more pronounced.

Figure 1
macro volatility has been very low since the mid 1990s despite some recessions along the way

New reality: Tighter monetary policy, greater cyclicality

Of course, over the past two decades-plus, there have been several times when systemic financial stability was compromised by built-up market imbalances and excesses — most notably, the 2008 global financial crisis. However, these transitional periods have typically been short lived, as the US Federal Reserve (Fed) and other world central banks simply ramped up their super-accommodative monetary backstops to contain the damage. As a result, real interest rates grinded ever lower and the economic cycle reverted back, relatively quickly, to "healthy growth with low inflation." A key takeaway from our analysis: Over the past 25 years, most global economies have spent on average 31 consecutive months in the "growth but little inflation" phase of the cycle. Figure 2 is a color-coded visualization of the dramatic shift to relative cyclical stability that began in the 1990s.

Figure 2
Are we returning to a time when economies transitioned through cycles more quickly?

It is impossible, in our view, to overstate the role that this limited cyclicality has played in defining asset returns and market structures over the past two-plus decades. For example, it has helped fuel the technology sector's relative dominance, as less cyclical volatility meant less risk associated with funding high-growth, high-"cash-burn" business models. It has undergirded the meteoric rise of passive investment strategies: The more central banks suppressed volatility, the more they stifled dispersion and opportunities within asset classes and across regions, making it more difficult for active managers to outperform. And it has incentivized capital concentration in top-performing assets, especially US assets, because from less cyclical volatility came more reliable market leadership.

Now, persistent global inflation and tighter monetary policy are poised to severely challenge those status-quo dynamics. As we noted recently:

"In a world where inflation rises, there is suddenly a ‘cost’ for central banks responding preemptively to every sign of slowing growth. They risk engraining even higher inflation expectations into the system. To prevent that, they can no longer be the stable, reliable backstops to the cycle. In that environment, monetary policy becomes more variable, with a higher chance of overtightening policy into downturns and overstimulating into upturns. Central banks become a source of volatility. And in that world, macro stability decreases. The economic cycle will no longer spend most of its time in one static state. Instead, it’s likely to frequently oscillate."

Implications for asset allocators: Pillars of our thinking

So, what does all of this mean for asset allocators? With macro regime change still in its early stages, a precise answer is unrealistic at this point. Moreover, greater cyclicality will translate to greater need for strategic flexibility on the part of allocators, meaning that the answer may be different at each stage of a given cycle. That being said, at a 30,000-foot level, here are five key pillars of our investment thinking as of this writing:

  • A higher, more volatile discount rate will impact asset valuations: In the new world we think we are entering, the discount rate will be higher and more volatile. The cost of capital will remain elevated. The implications of that should be steeper yield curves than in the past, wider credit spreads, and lower equity valuations, particularly for growth stocks most sensitive to the discount rate applied to future earnings.
  • There will be less “clustering” and more dispersion within asset classes: Ample market liquidity will no longer “float all boats,” so to speak. And deglobalization will structurally raise the corporate cost base. There will be more obvious winners and losers — greater differentiation between firms that can swiftly identify and adjust to change, control their costs, and wield pricing power, versus those that can’t.
  • There will be more variation among and “decoupling” of countries: Some countries will lean on fiscal policy tools, rather than just monetary policy, to address the economic and other challenges they face. But to a large degree, these will be politically driven choices: Different governments will make different decisions, depending on many factors, not least of which will be where the country is in its electoral cycle. We think these country-specific nuances will matter a lot.
  • Don't count on the historically negative correlation between bonds and equities: There will be extended periods when growth and inflation are moving in different directions, as there were during the 1960s, 1970s, and 1980s. The more explicit trade-off between growth and inflation will constrain the ability of central banks to react to weak or strong growth for long parts of the cycle. And that may have a destabilizing influence on the correlation between fixed income and equities, with bond returns perhaps no longer serving as a highly effective hedge against equities.
  • There will be higher value placed on being nimble and liquid: Less plentiful market liquidity and increased macro volatility may render the investment landscape more complex and fluid — in other words, harder to navigate. The implication here is that there will likely be greater value (and potential benefit) in being more nimble and liquid with asset allocation, as investor holding periods may need to be shorter in many cases.

Bottom line: Be prepared for a seismic global shift

Evidence continues to mount that a seismic global shift is underway that will disrupt the macro dynamics of the past two decades-plus. We believe asset allocators should consider taking appropriate steps to adapt their portfolios accordingly.

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