High volatility and erratic prices make short-term predictions very tricky.
The world continues to be impacted by disruptions related to the COVID crisis: delays in supply chains, fluctuations in demand, fiscal and monetary stimulus measures, tight labor markets, inflationary pressures, not to mention the war in Ukraine.
Uncertainty for Certainty
Economic collapse was initially averted through budget surpluses and monetary easing. From now on, these measures will give way to monetary tightening. The question remains when the next recession will occur. These important developments have three major consequences:
First of all, in these times when the economic parameters are out of their usual framework, it is very difficult to make precise short-term forecasts. Most economic models are not properly calibrated for such a context. Thus, for example, establishing expectations on the GDP or the CPI becomes a perilous exercise.
There is no similar precedent that could be used as a benchmark to assess future interest rates.
Second, uncertainty has increased considerably, particularly in relation to economic policy and business activity. So economic decision-making becomes more complicated, but also has a negative impact on risky assets.
Finally, these changes had a fundamental impact on the fixed income markets. Given the exceptionally high inflation and the reaction of the central bank, interest rates were repriced significantly. There is no similar precedent that could be used as a benchmark to assess future interest rates. Even the 1980s are incomparable. Therefore, the market has no benchmarks in pricing and sails by sight. This leads to greater volatility and sometimes erratic prices, making short-term predictions very tricky.
This is why, with regard to the bond outlook, it is necessary to focus instead on a medium-term vision. In other words, determining directions and anticipating trend reversals.
Caution is the mother of safety
Regarding the credit outlook, caution and investment grade bonds should be favored. In other words, pay close attention to business profitability. The CEO confidence indicator, an American indicator measuring the confidence of business leaders in the economy over one year, revealed a weakness which, historically, has augured economic slowdowns and higher spreads for high yield bonds. On the other hand, investment grade has already seen a significant widening of its spreads which, from a historical point of view, has gone very far.
A significant widening is also visible for high yield bonds. However, given the cautious economic outlook and the fact that historically high yield bond spreads tend to widen over longer periods, more caution is warranted on this asset class. In addition, investment grade will benefit from potential support from the ECB, or reinvestment of maturing bonds held by the ECB.
Apart from a less encouraging outlook for businesses, we have to look at the consumer side.
Convertible bonds are in a similar situation to high yield bonds. Nevertheless, as they have suffered more, their low cost makes them relatively attractive, although it is still too early to return to them.
These credit observations can influence positioning relative to interest rates. Apart from a less encouraging outlook for businesses, we have to look at the consumer side. Thus the latter is hit by a loss of real purchasing power due to higher inflation than wage increases. As a result, he dips into his remaining COVID savings and begins to borrow more; typical end-of-cycle behavior.
Observations for businesses and consumers raise questions about the strength of the current rate-tightening cycle. The markets are already anticipating that central banks will begin to ease their monetary policy within two to three years.
Given the uncertainty that remains on inflation, it is desirable to remain exposed to inflation-indexed bonds and maintain their overweight. The balance between lower growth and high inflation is complex. Overall, one should remain slightly underweight in duration, as rates have recently come down and therefore some slowdown is already anticipated.
As for central banks in emerging markets, they had tightened financial conditions long before developed markets, bringing real interest rate spreads back to pre-crisis levels. Carry has therefore returned to attractive levels. Although a certain wariness of lower quality credits should be maintained, as the deficit problems caused by the health crisis are likely to weigh on balance sheets.
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