Any hope that US inflation may be peaking were dashed last week as a bleak US inflation report showed price rises accelerating. The headline annual rate came in at 8.6%, up from the 8.3% seen in April, and above most forecasts. The increase was primarily driven by higher food and fuel prices, but there were also significant contributions from shelter (housing rents) and other areas, suggesting that inflation in the world’s largest economy was becoming more broad-based. There has been no let-up in the pace of inflation in the UK either, with the annual rate reaching 9.1% in May, and the Bank of England warning that price rises were likely to hit 11% by the autumn.
Most risky asset classes have posted sharp falls over recent days in response to the US data. This followed several weeks of falling government bond yields and even a brief recovery in global equity markets as investors began to factor in the potential for a softer central bank tone going forward. Instead, the US Federal Reserve hit the kill switch and opted for giant 75bp rate hike, its largest rate rise since 1994.
The Bank of England followed this a day later with another 25bp hike of its own, compounding the sense of gloominess circulating in financial markets.
With inflation remaining very elevated for now, it can feel like investors are suffering from a shrinking list of areas to park their cash. However, with significant year-to-date market falls already behind us, we would argue that there are now plenty of long-term opportunities for investors to consider in the fixed income space.
While many bond investors who avoided being overly exposed to duration have been rewarded on a relative basis during the sell-off so far this year, we think now might be the time to start reversing some of these positions. Base effects could mean that we see well-publicised annual inflation figures come down over the course of 2023, which should be positive news for bond markets, particularly as a US-led hiking cycle now appears to us close to becoming fully priced in. The 10-year forward rate in the US Treasury bond market (the average expected Fed Funds rate in 10 years’ time) is currently 4% – historically this has been a strong buy signal for US Treasuries.
Another area that is looking historically attractive is emerging market debt, which has seen significant drawdowns this year, having experienced heavy investment outflows year-to-date and now very elevated yields. Despite the ongoing strength of the US dollar and global economic headwinds, we think there are now some very attractively priced areas of the market on offer. Performance in regions such as Latin America, for instance, has remained relatively well insulated from the effects of the war in Ukraine, and many countries there continue to benefit from elevated commodity prices.
Similarly, developed market investment grade credit has been very underappreciated lately. While market liquidity remains challenging in some areas, we feel there are now opportunities to selectively add new positions from here. Braving corporate bond exposure hasn’t been easy given some of the anaemic returns we’ve experienced over the last few years, but we are seeing signs of increased interest in this area of the market, with clients clamouring for products offering higher yields on their investments – the yield on global investment grade credit has doubled over the course of 2022 and now sits at close to 5%.
We shouldn’t discount a scenario where bonds get significantly cheaper from here – they still might, particularly if the inflation picture continues to deteriorate. While we expect inflation to cool soon, it seems likely to remain elevated well above many of the major central banks’ inflation targets for some time yet. A policy-induced hit to global growth could also cause corporate default rates to rise. However, we do think the sell-off has created a compelling opportunity to pick up assets at highly attractive prices, with wider credit spreads potentially offering a cushion against any further rise in interest rates from here.
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