Key themes for fixed income in 2023

• Policy moderation not accommodation from central banks
• Economic and policy bifurcation
• A rise in credit defaults
• A more discerning “greenium” that rewards issuer quality not just use of bond proceeds
• An opportunity to invest in quality bonds at yields not seen in more than a decade

Policy moderation not accommodation from central banks

Bond markets faced myriad challenges in 2022, amid the fastest monetary policy tightening cycle enacted by global central banks since the 1980s in a bid to rein back surging inflation.

In 2023, the market will remain focused on the path for inflation and justified in asking questions about the potential terminal rate for central bank policy. Another key theme for the coming year will be a rise in default risk as corporates navigate higher refinancing costs and the stagflationary environment. Risk premia in credit markets have started to adjust accordingly.

On rate policy, we believe it would be a mistake to expect an accommodative or dovish stance from central banks until inflation is well and truly under control. Fed Chair Jerome Powell has already warned the terminal rate might be higher than market forecasts, with some other members of the rate setting committee – the FOMC – suggesting a potential range of 5% to 7% range.

A regime shift is also underway, with the structural factors that have kept inflation low for over a decade, such as globalisation, clearly unwinding. Those expecting a rate cut next year could well be disappointed. The 2% inflation target is unlikely to be met as quickly as guided without a deep economic contraction, so you could see a period where central banks keep conditions tight while potentially tolerating a rate of inflation of roughly 3.5%-4.5% to avoid economic scaring.

Shaped by a decade where central banks acted as the buyer of last resort, market expectations might take time to catch up with this new reality. Given how forcefully inflation reared its head in 2022, albeit exacerbated by unforeseen supply-side constraints, central banks will be reluctant to avail stimulus too readily or to enact cuts as swiftly compared to recent years. We are now in an era where central banks will deploy more traditional monetary tools, with unorthodox policies such as QE and TLTRO pushed to one side.

Economic and policy bifurcation

Bifurcation is likely to be an important feature of the outlook for inflation, interest rates and the pace and depth of the economic contraction. Inflation prints in the US and Canada have already started to moderate at 7.1% and 6.9% respectively, compared to figures of 10.7% and 10.1% in the UK and Eurozone. This will have implications in terms of monetary policy divergence and a rebalancing of currencies. Should inflation decelerate decisively, the US rate hike cycle may peak sooner than cycles Europe and the UK, although we believe the Bank of England is similarly wary of ‘over-tightening’, in part given the dampening effects of the fiscal measures announced by the UK government. Nevertheless, each region has different factors driving down inflation. In the US, it will likely be a tick up in unemployment. Europe, meanwhile, is obviously working through a sharper downturn and an energy crisis brought on by the war in Ukraine.

Additionally, Labour market disquiet has been a growing theme in 2022, particularly in the UK and is likely to persist into next year, with core inflation proving ‘stickier’ and thus more difficult for central banks to curtail. In the UK real wage growth is still deeply negative and a resolution to current strikes and wage demands without a hit to company margins appears unlikely. This is less of a problem for North America.

A rise in credit defaults

The global recession – or, indeed, period of stagflation – is already posing challenges for corporates with refinancing needs. This will become more acute in the year ahead as the combination of softer demand, rising input prices and wages squeezes margins. Credit spreads are already starting to reflect the higher risk environment for some issuers whose true funding concerns were arguably masked by the abnormally lower interest rate settings maintained by central banks over the last decade.

A more discerning “greenium” that rewards issuer quality not just the intention behind the bond

Green and sustainable bonds continue to attract a premium and the issuance pipeline remains robust with companies and governments increasing the urgency of their decarbonisation and broader sustainability plans.

However, the market has become far more discerning about which issuers it rewards with a greenium. We are seeing a disparity between the prices paid for high-quality best-in-class issuers and businesses bringing labelled debt to market that lack strong sustainability credentials themselves. Green bonds from the latter still receive a greenium but on less favourable terms than green issuers – a clear departure from the earlier stages of the markets for green and sustainable bonds, when market participants were perhaps less discerning.

The market’s increased scrutiny of issuers, not just bond issues, vindicates our long-standing approach where we assess the quality of both. The issuers’ overall impact matters to us.

On a technical level, it is worth noting that the greenium has been compressed by the rise in interest rates overall and is therefore lower, but it still exists for better rated players.

An opportunity to invest in quality bonds at yields not seen in more than a decade

While the outlook for interest rates and the global economy remains challenging, we are seeing opportunities to invest in high quality bonds at yields we have not seen for more than a decade.

Although the immediate direction of travel is still upwards from an interest rate perspective, the reduction in the pace of monetary policy tightening being signalled for the year head warrants a change in duration positioning. To that end, we began moderating our shorter-relative duration stance across the Fixed Income Fund range in November with a view to neutralising duration vs benchmarks should slowing inflation and weaker economic growth conditions lead central banks affirm a pause in ongoing interest rate hikes over the coming months. Nevertheless, we still generally prefer the short end of the curve given the uncertainty that remains about how aggressive central banks are likely to be. We would like to see stronger signals that the inflation picture has improved before moving too far out on the curve.

In the context of potentially higher risk premia (and default risk more generally) as corporate earnings re-adjust to this backdrop, credit quality remains crucial. As such, we maintain a bias towards higher investment grade rated debt.

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