Capital Ideas^TM

Generating income is a key role of fixed income. For investors, the durability of income streams becomes more important amid heightened volatility in both equity and bond markets.

Capital Group portfolio manager Damien McCann provides context around current global trends in inflation and rates and shares his insights on where he is finding relative value across credit markets to help deliver consistent and durable income streams.

There is a silver lining to current market volatility

2022 has been a very difficult period for fixed income investors as central banks have aggressively hiked interest rates in an attempt to slow the economy and reduce inflation. We are already seeing the impact from these tighter financial conditions. Global PMIs for both manufacturing and services suggest growth is now flat across the world. In Europe, sentiment and business conditions indices have dropped to the lows of the COVID pandemic and the 2011 European sovereign debt crisis. In China, the property sector still needs to deleverage further and loan demand growth is barely positive. As for the US, housing activity is experiencing a deep contraction. Consumer and business confidence is weak and while the job market is still strong, job cuts are rising.

The overall picture of slowing economies across the globe will continue into 2023.

The US rates market is pricing in a Fed Funds rate approaching approximately 5% by the middle of 2023. This level is broadly consistent with the expectations of Capital Group’s rates and inflation research team. The team also thinks inflation is in the process of peaking, although any decline is likely to be gradual. While there is much uncertainty, inflation isn’t expected to approach the Fed’s 2% target before 2024-25, if not later.

What does that mean for fixed income? Persistently high inflation may put additional upward pressure on rates beyond what markets are already pricing in. However, slowing economic growth could begin to exert downward pressure on rates. This leads me to have an overall neutral stance on duration.

In terms of curve positioning, I am positioned for a steeper yield curve. The curve has flattened considerably, but as weaker economic growth takes hold, I expect this flattening will start to reverse.

The silver lining of the weak returns in bond markets over the year-to-date is much higher yields available to fixed income investors than we've seen in many years. I think this sets the stage for positive returns going forward.

Inflation: A global perspective

Looking at trends across a few major markets, we see that inflation is raging in Europe but is modestly off recent highs in the US. Inflation is notably higher in China and Japan, but at 2.5-3%, it is quite modest compared with most other places.

A year ago, a majority of inflation indicators, such as housing and commodity prices, overall money supply, wages, stock prices, were pointing higher. Today, many of these measures have moderated; housing prices seem to be rolling over, commodity prices are well off their highs, money supply is now contracting, and equities have sold off. The cumulative impact is less inflationary pressure.

Emerging markets provide an interesting perspective. We have seen a correlation between when central banks started to hike rates and current inflation trends. For example, Latin American central banks, which have mandates focused purely on inflation, began to hike rates six to 10 months earlier than the US Federal Reserve. In these countries, inflation has started to fall. Inflation in Brazil has fallen to 7% from 12% and there are encouraging trends in Peru and Mexico.

Asia is the opposite. In Thailand, China and Japan, for example, central banks are not as singularly focused on inflation as their Latin American peers. These central banks tend to have a dual focus of growth and inflation and have therefore been slower to hike. As inflation becomes a bigger problem, they are more focused on hiking.

Another angle, not specific to any single geography, is the competing effects of the cyclical and structural elements of inflation. The factors that support the argument that US inflation is peaking can be classified mostly as ‘cyclical’. Balanced against that are important structural factors that point to inflation not quickly returning to the Fed’s 2% target. For example, structural shortages in the labour market, largely due to COVID, as well as the impact of a reversal of globalisation, are both inflationary.

Therefore, while I think inflation is peaking, that is primarily in the US. I don’t expect it to roll over quickly and it is likely to come down gradually.

 

Risk factors you should consider before investing:

• This material is not intended to provide investment advice or be considered a personal recommendation.
• The value of investments and income from them can go down as well as up and you may lose some or all of your initial investment.
• Past results are not a guide to future results.
• If the currency in which you invest strengthens against the currency in which the underlying investments of the fund are made, the value of your investment will decrease. Currency hedging seeks to limit this, but there is no guarantee that hedging will be totally successful.
• Risks may be associated with investing in fixed income, emerging markets and/or high-yield securities; emerging markets are volatile and may suffer from liquidity problems.