Investors have reason enough for concern. Markets are volatile. Inflation is persistent. Recession risk looms.
But there is a bright spot to consider: With yields now higher, we believe bonds are attractive again.
In our latest Cyclical Outlook, we discuss the case for bonds, including greater potential for income and diversification than seen in years, in our view. We also discuss other assets and analyze in detail the factors driving inflation, as well as the monetary responses and the potential for recession. This blog post summarizes our views of the next six to 12 months.
The economic backdrop
Geopolitical tensions, elevated market volatility, and the fastest pace of central bank tightening in decades are contributing to an unusually uncertain economic environment.
Our baseline forecast is for shallow recessions across developed markets, especially in the euro area and the U.K., which face disruptions from the war in Ukraine. U.S. real GDP will also likely experience a period of modest contraction.
Meanwhile, core inflation rates that are above central bank targets now appear more entrenched, and although headline inflation is still likely to eventually moderate meaningfully over our cyclical horizon, it now looks likely to take more time.
The combination of higher unemployment and stubbornly above-target inflation has put central bankers in a tough spot, but their overall actions to date suggest they are squarely focused on bringing inflation down. In the U.S., for example, we expect the Federal Reserve will raise its policy rate to a range of 4.5%-5% and then pause to assess the impact on the economy of its tightening.
Investment implications
With higher yields across maturities, we believe the case is now stronger for investing in bonds. We believe high quality fixed income markets can now be expected to deliver returns much more consistent with long-term averages, and we think the front end of yield curves in most markets already price in sufficient monetary tightening.
We see abundant opportunities to look to harness this growing value in bond markets. For example, investors could combine exposure to high quality benchmark yields - which have increased significantly in the past year - with select exposure to high quality spread sectors, and add potential alpha from active management. We believe the return potential is compelling in light of our cyclical outlook, and that many investors could be rewarded by returning to fixed income….
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