Markets have began to price in a recession given the combination of quantitative tightening and rate rises on the global economy.
However, the reaction of the bond market relies on whether it is a true, or a shallow recession, according to Andrew Mulliner, head of global aggregate strategies at Janus Henderson.
Year-to-date, bonds and equities have fallen together, leaving investors nursing losses across their portfolios.
The traditional relationship between stocks and bonds has broken down and, in this environment, it may be better to hold cash and wait for price dislocations.
“In the past few months that has certainly been the case if bonds, equities and cash were your only choices,” said Mulliner.
“Clearly commodities have performed well, and parts of the equity market related to energy and commodities have also delivered positive returns.”
Lot’s of value in fixed income
He argued, however, that cash is still the ultimate low-yielding asset class and offers little positive real return over the long-term.
“Given the stark repricing in fixed income, there’s certainly a lot more value to be had these days, government bond markets now price significant monetary tightening in their term structure,” said Mulliner.
In credit markets, investors can now find a yield of 6.6% in European high yield and 7.6 in US high yield.
“This prices in a lot of bad news as well as higher rates, so from a medium-to-long-term perspective bonds now seem pretty appetizing, albeit near-term volatility is extremely high,” he added.
Government and low risk bonds are, in theory, meant to balance the volatility of equities, but lately the diversification relationship has broken down.
“I think we are already getting pretty close to bonds being diversifying again now,” said Mulliner.
“That is partly reflective of the fact that we have priced a lot of tightening into the bond markets and partly it also reflects that economic data is showing some signs of weakness now, so the growth versus inflation trade-off is not as straight forward as it once was.”
However, this relies on economies hitting peak inflation, something Mulliner argued has likely occurred in the US, but not quite in Europe.
“With inflation having peaked and lots of tightening priced in, bonds should offer investors that hedge quality again.”
With tightening priced in then, investors could find shelter in long-dated government bonds.
“Clearly, we have a lot of volatility and a degree of uncertainty too, so buying very long duration assets is not a trade without risk,” he said.
“If you have a long-time frame or alternatively a set of liabilities to be managed, then these yield levels are pretty attractive.”
Time for emerging market bond exposure?
Mulliner thinks while yields in emerging markets look interesting, it is perhaps too early to be getting involved, given the spike in food and energy prices.
“The high inflation is likely to cause political pressure in some of these countries, as we are already beginning to see, but in the next six to 12 months we think there should be some attractive opportunities for investors in emerging markets.”
This current policy of tightening and rate hikes could trigger a recession and precipitate a sell-off in markets.
Mulliner outlined that it depends on the type of recession that emerges.
“A true recession which cause a material move higher in the unemployment rate would be good for government bonds, given how much tightening is priced in,” he argued.
“It would be bad for credit – although spreads are already internalising a pretty negative growth outlook, so we wouldn’t expect material loss of capital given the starting point.”
He said that if the recession is shallow and labor markets remain robust, then the outcome is less clear cut.
“Whilst the Fed and other central banks may slow the pace of their tightening, they are unlikely to give up on higher rates considering where inflation is,” he said.
Mulliner argued that central banks must assess how tight the labor market is and whether it can allow a transmission of high inflation today into wage settlements which will allow a persistence of that inflation through time.
“With a higher unemployment rate and slack in the labour market, this transmission method is unlikely to kick in and therefore a more benign approach from the central banks is possible.
“If labor markets stay tight, this assumption cannot hold true and central banks will need to keep their foot on the throat of inflation in spite of weaker growth.”
