How much market stress is enough
Fixed Income OutlookFrom this perspective on fixed income, we oppose the Federal Reserve
forecast for the US economy compared to its – modest – projections for the Fed
funds rates, while highlighting credit opportunities, particularly in
Europe versus the United States and in the banking sector. In emerging markets, our priority
is on Asia, and more particularly on Chinese debt in local currency.
If you look at the mandate of the Federal Reserve, how much the
United States towards full employment?
- The unemployment rate fell sharply, while
the employment-to-population ratio has recovered. But the labor
the participation rate is not at its maximum.
- Workers leave voluntarily and change
jobs at high rates – historically a good indicator of a tight labor market.
- Tightness is also apparent in the compensation
metric. Employers must raise wages and improve working conditions to
Minutes from the December policy makers meeting suggest
that some FOMC members come to the conclusion that the economy is close
Will higher wages keep inflation going? This costs
noting that salaries – according to the Atlanta Fed’s Wage Tracker (see Exhibit 1)
– are on the rise at all levels.
This comes at a time when the term “transient” describing
inflation is no longer useful. Inflation is spreading beyond basic goods to
services. The firming up of the evolution of primary rents and owner-equivalent rents – a
major component of inflation – should last at least a year.
Given the Fed’s inflation forecast – as well as
growth and employment – we believe that its projections for key rates do not
align with these forecasts. It is strange that the rates are still below the
Estimate of a neutral rate of 2.5% by the end of 2024, with unemployment at just 3.5% and
core inflation still above the 2% target.
We therefore expect the Fed to continue raising its rate forecast.
as it seeks to bring inflation back to its target.
The first rate hike could come in March, with moves towards
track at every political meeting by raising rates to 2.5% or more by the end of
2023. By comparison, current market prices suggest policy rates will peak at
around 1.8% at the end of 2024.
There are several reasons to expect rapid normalization
key rates. Household finances are strong, corporate profits have soared,
the economy is already close to full employment, core inflation is at its
highest since the early 1990s, yet the benchmark for the real 10-year Treasury note
yields are still clearly negative.
In the euro zone, we believe that the peak of inflation is near.
For inflationary pressures to persist, inflation must feed through to
wages. We expect wages to rise further in 2022, but probably not enough
generate an increase in real disposable income.
High inflation figures led to more warmongering
communications from the ECB. He left the door open to the key rate
increases once the Pandemic Emergency Purchase Program (PEPP) ends, while the
more established asset purchase program (APP) still works.
The ECB gave itself the possibility of raising its rates as soon as
like in 2023. We actually expect the ECB not to raise rates until 2024.
Inflation probably won’t peak at least until April
given the improvement in the economic outlook, tensions in the consumer goods markets and
skyrocketing utility prices. There are signs that wage increases are continuing,
although at a slower pace.
Given these developments and inflation forecasts, we estimate
the Bank of England will likely follow its December takeoff with a rate of 25 basis points
increase in February.
The UK yield curve could steepen over the medium term as
central bank demand for gilts falls. Given the orientations of the BoE, we believe
short-term yields are unlikely to price in a rising rate cycle
beyond 1%, while longer-term yields could rise further on BoE outlook
While we can expect US policy rates (and real yields)
increase in 2022, we do not see this as a material risk to economic growth or
company profit. Monetary policy is just normalizing.
At 4% YoY in Europe and 9% in the US, 2022
consensus earnings growth estimates are significantly lower than last year, but
revenues should more than cover interest payments. Indeed, many credit indicators
are better now than before the pandemic (see Figure 2).
We expect Eurozone corporate bonds to outperform US bonds
given the diverging monetary policies. While the market is currently pricing
several rate hikes in the US this year, there could be at most one ECB decision.
We are positive on high yield. With an above-trend economy
growth likely this year, the outlook for credit quality is reassuring.
Among the sectors, we are the most positive on the European banking sector
given the improving economic outlook and the possibility of an increase
tariffs (particularly in the United Kingdom).
Since we expect US yields to rise significantly in 2022, we
favoring a short duration for hard currency emerging market debt. At the regional level,
outsized returns should be driven by Asian high yield bonds given their
attractive valuations and the possibility of significant spread narrowing.
When it comes to default rates, we believe 2022 will be a turning point.
Investors should recognize Asian credit as an important and diversified asset class
beyond Chinese property developers. We expect a significant rally.
We see room for a marked reallocation of assets towards
Chinese local currency debt underheld amid further policy easing
the rest of the world is in a tightening phase.
More generally in emerging markets, we see attractive opportunities in
local currency bonds when currencies and emerging market rates begin to recover. In addition,
2022 will be a year of innovative thinking on environmental, social and
governance factors as investors begin to appreciate ESG issues in emerging countries
All opinions expressed herein are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may have different views and make different investment decisions for different clients. The opinions expressed in this podcast do not constitute investment advice.
The value of investments and the income from them can go down as well as up and investors may not get back their initial investment. Past performance does not guarantee future returns.
Investing in emerging markets, or in specialized or restricted sectors is likely to be subject to above average volatility due to a high degree of concentration, greater uncertainty as less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).
Some emerging markets offer less security than the majority of developed international markets. For this reason, portfolio transaction, liquidation and custody services on behalf of funds investing in emerging markets may involve greater risk.
Written by Investment Insights Centre. The post Fixed income Highlights – Policy divergence first appeared on Investors’ Corner – The official blog of BNP Paribas Asset Management, the sustainable investor in a changing world.