Our expectation that financial market developments in 2022 would not be like 2021 did not take long to materialize! January was an eventful month, which led to even more interesting developments in early February, which are sure to have long-lasting effects. To recap January/early February: equities down, in many places quite sharply; credit spreads meaningfully wider; and, potentially most importantly, government bond yields up materially as central bankers, seemingly en masse, threw-in-the-towel on “transitory” inflation. The practically coordinated global central bank pivot to accelerate monetary tightening (or, in central bank speak, removing accommodation) surprised the market which had anticipated a more sedate, orderly transition to rate hikes in the 2022/2023 period. This monetary policy conflagration impacted everything. The only assets not spilling red ink were oil, the U.S. dollar, Emerging Market (EM) local (surprising, yet not surprising), and bank loans.

Last month we posed three questions: How impactful will Omicron be?  Should markets fear the Fed?  And, lastly, will inflation fall?  While the surge in Omicron infections has no doubt hit economies, its impact still looks temporary, meaning lost output in Q1 2022 will likely be made up in later quarters. Labor markets remain resilient and, probably most importantly, central banks appear to be looking through it and not changing strategy.  Indeed, some highly vaccinated European countries like Denmark and the UK are in the process of eliminating all COVID restrictions and returning to normal in terms of social distancing, vaccine requirements, mask-wearing etc.  It remains uncertain if these health policy changes will spread and stick.  But, for now, we can assume Omicron will fade as an issue for economic activity and policy behavior, except in China, which is a significant outlier.

On the other hand, the outlook for central bank behavior has been upended.  Not only has the U.S. Federal Reserve (Fed) not pushed back against the market pricing in multiple rate hikes in 2022, it has also effectively acknowledged that it has fallen behind the inflation curve (Chairman Powell said he was already marking up his end of year inflation forecast), necessitating a quicker than usual pivot from Quantitative Easing (QE) to Quantitative Tightening (QT – i.e. balance sheet run off). 2021 market expectations of three rate hikes shifted to five by early February, post FOMC meeting, and the possibility of hiking by 50 basis points (bps) at a meeting, rather than just 25 bps, has also been flagged. Indeed, Chairman Powell has gone out of his way to confirm that this tightening cycle will differ from the 2015-2018 cycle in several ways: rate hikes could occur faster as inflation is substantially above target rather than below and QT is unlikely to meaningfully lag rate hikes; employment is growing rapidly; wages are rising at their fastest pace in decades; inflation is picking up globally, so there is no offset from offshore deflationary pressures; and supply side issues, either on the goods or labor force participation rates, are NOT going away.

If only it was the Fed acting hawkishly, it might not have been so bad.  But the Fed was joined by the ECB, Bank of England, and the Bank of Canada in delivering more hawkish than expected messages or actions (in addition to the litany of emerging market central banks who continued to aggressively raise rates in January).  In particular, the ECB was considered a dyed-in-the-wool dove, with no plans to raise rates or significantly reduce accommodation in 2022.  Well, forget that. The ECB has caught the inflation worry bug and can no longer be expected to keep rates unchanged in 2022. It was only two months ago that analysts and the ECB were fairly convinced that there would be no need to raise rates until 2024!  German government bond yields rose significantly in January as markets digested monetary policy developments.  Net, net, central banks are getting their wish of tighter financial conditions before anyone has raised rates (outside of the UK, Norway and New Zealand, which have raised rates) by weakening financial markets.

Lastly, the inflation outlook remains of paramount importance as central banks ARE responding to continued positive inflation surprises. There is good news and bad news on this front.  First the good news.  We believe inflation will come off the boil in the first quarter as energy inflation subsides. This will be the first drop in this expansion. The expected drop in developed market headline inflation does not mean that core inflation will drop, with inflation  proving much stickier than anticipated.  The trajectory of core inflation has been buffeted by both supply and demand shocks. While the demand should fall gradually in 2022, the supply side of economies are not recovering as anticipated. Energy prices in Europe, wages globally, but particularly in the U.S., are not behaving.  As such, central bankers have adopted a much more hawkish posture to try to convince markets that inflation will not be allowed to become entrenched at a level meaningfully above medium-term targets. Core inflation should stabilize at a minimum, and hopefully fall, if only marginally, but this is not likely to happen until the end of Q1.  Do not expect central banks to relieve pressure on markets in Q1.

In terms of market views, we have been reducing portfolio risk given the uncertain outlook. We remain modestly long higher-yielding, shorter maturity assets (corporate credit, securitized credit, emerging markets).  Economic growth should still be above trend in 2022; inflation will likely fall after the first quarter and, most importantly, we do not believe central banks want to create tight financial conditions; they want to get policy to neutral fairly quickly, but that should be it. Inflation is NOT completely demand-led and higher rates will not fix the supply side of the economy. We expect developed economy government bond yields to continue to move higher but, given how many rate hikes are now priced into yield curves, there could be some stability in the near term if inflation stabilizes. The risk is that it does not.

Fixed Income Outlook

January was a difficult month for financial markets.  Two intertwined factors drove performance: inflation and central banks.  Inflation data continued to surprise on the upside across both the developed and emerging markets.  As a result, central banks continue to talk more hawkishly than before. Yields rose everywhere: on government bonds, corporate bonds, emerging market bonds, securitized assets.  There was no real “safe haven” in fixed income assets except cash and floating rate products like loans.  Whether or not this continues for the rest of 2022 will depend crucially on how this inflation/central bank dialectic plays out.

Before getting into inflation and monetary policy, Omicron issues need to be dealt with.  While we and many others were concerned about how the Omicron infection wave would impact markets, it does not look like it will be a major force in the months ahead.  This is not to say it has not been impactful.  It has.  Recent economic data in Europe and North America has been negatively impacted.  But crucially this should be temporary without having longer-term repercussions.  Thus, positive trends in economic data should reassert themselves, as should current central bank behavior.  Despite an expected weakening of economic activity in 2022, growth should remain well above trend in most countries, crucially in the Eurozone and United States.  This is supportive for corporate and government cash flows and supportive of corporate credit in general.  The widening in spreads seen so far in 2022 increases their relative attractiveness but we are leery of adding to exposure just yet.  Importantly, whether this expected strong cash flow year materializes will depend heavily on the inflation outlook.  For if inflation does not fall as anticipated by central banks (and the market), monetary policy settings may need to be moved to a restrictive setting with all the negative ramifications the word implies.  So, what about inflation?

Unfortunately, high, and persistent levels of inflation have triggered changes in monetary policy expectations. The trend of central banks globally reducing accommodation is intensifying relative to what was expected a short while ago.  The aggressive repricing of short rates, none the more surprising to the market than in the Eurozone.  German 5-year yields rose 23 bps in January and another 26bps in the first four days of February to their highest level since 2018!  Now that is a repricing.  While U.S. Treasury yields have also risen significantly this year (10-year maturities up 40 bps through February 4), they are only getting back to where they were pre-pandemic. If economies are truly returning to “normal,” there is no reason NOT to expect monetary policy settings to revert to “normal.” But, if inflation dynamics prove to be stubborn, central banks may need to push policy settings to restrictive territory, reinforcing the natural economic slowdown occurring in 2022, risking a rising probability of a recession in 2023/2024. Certainly, markets are testing central banks’ commitment to capping/reducing inflation this year by pricing more aggressive rate tightening cycles, including in the Eurozone.  Importantly, central banks have not pushed back at all on market pricing.  But a disconnect between central banks and the market does exist with regard to how high rates must go to achieve lower and at-target inflation.

One of the biggest surprises in 2021 was the decline in real yields. This year the surprise has been the other way around.  Real yields have risen substantially and much faster than anticipated.  But, unfortunately, they will likely have to move higher still in 2022 if they are to return markets to “normal” pricing, consistent with medium term growth expectations.  The real 10-year U.S. Treasury yield, while already rising 53 bps this year through February 4, is still significantly negative.  This is a very pessimistic forecast and one unlikely to be true if secular stagnation does not return (although we cannot completely dismiss the possibility).  The depressed state of real yields is a function of a variety of factors that should dissipate in importance, like excessively easy monetary policy.  Importantly, the Fed needs real yields to rise to slow inflation.  How high they need to go will depend on the financial market’s reaction. The more long-term yields rise, the less tightening is required from the Fed. The expected move to begin QT this year adds an element of uncertainty as markets do not have much experience in handicapping a higher rates/QT combo (nor does the Fed).   Therefore, nominal, and real yields should move higher in 2022 as liquidity is withdrawn, the economy slows and inflation falls.

With the global central bank “peloton” moving together, constraints on any one country’s monetary policy or level of yields is relaxed.  For instance, one reason U.S. yields remained so low in 2021 (and previous years) was the huge amount of negative yielding bonds in the world.  U.S. yields were high by global standards, encouraging capital inflows, capping yields.  With all bond yields moving higher and global central banks tightening policy somewhat synchronously, there is more scope for ALL yields worldwide to rise. Indeed, the rise in Eurozone yields is particularly important given the extent to which euro-denominated investors have historically chased higher yields in other markets. This is an important reason why bond yields could surprise the market to the upside, assuming central banks follow through on their tightening agendas, which depends on how inflation behaves.  There is a lot of front-loaded tightening priced into almost all developed market yield curves. Whether or not this happens will depend crucially on how inflation behaves through March, and eventually beyond.

The pace of tightening is not the only thing to worry about.  One crucial factor keeping longer maturity yields relatively low is expectations that terminal rates, i.e., the peak in policy rates, will not reach new highs.  Indeed, current market expectations are that peak rates this cycle will be meaningfully lower than last cycle (2015-2018).  The risk to bond valuations is that this is wrong.  The Fed, for example, thinks short rates will peak around 2.5%, much higher than what the bond market is currently pricing. With inflation proving to be stubborn, there is a danger that expected terminal rates will have to be adjusted higher by both the market and Fed. There is also the risk that the reversing of QE programmes will impact longer maturity bonds in particular, given that the original rationale of many of these programmes was to drive long-dated yields lower. That said, we believe inflation will fall in 2022, growth in output and employment will slow, and the Fed will calibrate its tightening cycle as more information arrives.  It may be true that this is just an inflation scare.  By mid-year, when we know more about how fast inflation is falling, the Fed will be able to slow down its tightening.  Of course, the opposite is true as well. In the interim, it will be hard to fight the Fed!

Credit investors have become more nervous recently, causing credit spreads to widen; we think this is reflective of how tight spreads have become, anticipated reductions in liquidity and the anticipated Fed (and other central bank) tightening, rather than any meaningful increase in default or cash flow risks. Further widening could be a buying opportunity but we will need to see some stability, if not outright falls, in inflation to be confident.  EM local market risk is improving as central banks get a handle on the inflation situation.  Very hawkish central banks, with inflation pressures still evident, make it premature to get bullish, despite significant rate hikes in recent months.  But this could change by the end of the quarter when more evidence is available on the global inflation trend.

Where does this leave our views on markets? In general, we remain overweight shorter-maturity higher yielding sectors.  We think high yield (HY), securitized credit and floating-rate loans will outperform government bonds, agency mortgage-backed securities (MBS) and investment grade credit, but by less than in 2021. We think low expected terminal rates and negative real yields make longer-maturity bonds relatively unappealing.  We do not think a return to neutral Fed policy is something to be overly concerned with.  However, this outcome is contingent on the Fed not overdoing it, either on purpose or by accident.  If markets sense recession risks rising, performance rankings will flip with investment grade and government bonds expected to outperform.  Local EM looks interesting given how much central banks have raised rates. On the external side, we are more selective, but do expect high yielding sovereign bonds to reverse their 2021 underperformance.  Once inflation peaks, substantial risk premiums should fall.  Shorter maturity bonds are more interesting due to much higher risk premiums now priced in. How China manages their zero-COVID strategy will also be impactful both on the demand and supply sides.

Developed Market Rate/Foreign Currency

Monthly Review

The year did not start quietly for developed market rates. In January, yields rose broadly following further hawkish sentiment from central bankers. Additionally, inflation worries continued and geopolitical concerns arose. Pressured by higher discount factors given increased rates and demanding valuations, risk assets sold off considerably. Regarding COVID, data continues to indicate that the Omicron variant is a dwindling threat. The U.S. dollar rose slightly during January.¹

Outlook

Central bank policy will continue to dominate markets going forward. While a more hawkish bias has been confirmed, there is still speculation about just how quickly central banks could tighten, with the Fed and others indicating they may be happy to raise rates quicker than 100 bps per year, as was typical in the previous rate hiking cycle. Overall, we see value in many emerging market currencies vs. G10, but many still have elevated risks. Amongst G10 currencies, we see limited valuation differences.

Emerging Market Rate/Foreign Currency

Monthly Review

Broad market volatility impacted the hard-currency segments of the market, as spreads widened for both sovereign and corporate credit, and the move higher in U.S. Treasury yields had a direct hit. Local currency was essentially flat and outperformed most other areas of markets. Local sovereign debt were still negative,² as was U.S. dollar-denominated corporate debt.³ U.S. dollar-denominated sovereign debt was also down. The asset class experienced outflows, with approximately -$2.2 billion net in January.⁴

Outlook

We remain constructive on the emerging markets, given the balance of fundamentals and valuations. Fundamentals appear stable, with global growth and trade continuing their rebounds, albeit at a slower rate. Many central banks across EM have tightened policy well ahead of the Fed and other developed markets, and inflation appears to have potentially peaked in many spots. COVID continues to be a challenge for many EM countries, but potential “lockdown” policy responses would be the most impactful for markets and, so far, appear unlikely in most areas.

Corporate Credit

Monthly Review

Investment grade credit spreads widened in January due to the volatility in risk markets. The news was dominated by a number of negative themes that drove sentiment – continued high inflation, Russia-Ukraine geo-political risks, and Omicron.⁵

The high yield market began the year with the worst return for the month of January on record. A continuation of hawkish messaging from the Fed was the primary catalyst. Treasury yields leapt, credit spreads generally widened and fixed rate products sold-off.⁶

Global convertibles had the worst start to a year on record as investors weighed the impact of rates rising on growth stocks. Energy names performed best along with Financials, while Technology, Communications and Consumer Discretionary fared the worst.⁷

Outlook

We expect Investment Grade (IG) credit to trade in a range earning carry with limited capital gains from spread tightening. We continue to expect volatility in early 2022 given the current uncertainty and lack of appetite for risk positioning.

Floating-Rate Loans

Monthly Review

Loan returns for January were favorable relative to other areas of investor portfolios, as U.S. stocks, high-grade and high-yield bonds sold off sharply during the month on expectations of rising interest rates. Results were strongest in the opening half of January as the market carried over momentum from the end of 2021, later easing in the second half of the month as market volatility increased.⁸

Outlook

We expect continued strong technicals and fundamentals. Above-trend economic growth, the likelihood of declining inflation levels, and the possibility of Fed rate hikes should all play into an investment narrative that supports the loan allocation and thus provides support for current valuations. At the same time, broad-based improvements in credit metrics, a very low default outlook and a likely continued strong technical tone in the asset class should serve as helpful forces as well.

Securitized Products

Monthly Review

Agency mortgage-backed securities (MBS) underperformed in January with spreads almost reverting to pre-pandemic levels as the market anticipates the end of quantitative easing and potentially the beginning of quantitative tightening. The spike in rates volatility and lengthening durations from rising mortgage rates are also weighing on the sector. Non-agency Residential MBS (RMBS), Commercial MBS (CMBS) and Asset-Backed Securities (ABS) spreads were generally wider during the month, however performance varied by sub-sector.⁹

Outlook

We believe the securitized market still offers a unique combination of low duration, attractive yields and solid credit fundamentals. We remain constructive on securitized credit and have a modest credit overweight across our portfolios. We remain cautious on agency MBS and interest rate risk, and we continue to manage the portfolios with relatively short durations.

¹ Source: Bloomberg. Data as of January 31, 2022. 

² Source: JPM EMBI Global Diversified Index.  Data as January 31, 2022.

³ Source: J.P. Morgan CEMBI Broad Diversified Index.  Data as of January 31, 2022.

⁴ Source: J.P. Morgan GBI-EM Global Diversified Index.  Data as of January 31, 2022.

⁵ Source: Bloomberg. Data as of January 31, 2022. 

⁶ Source: Bloomberg U.S. Corporate High Yield Index. Data as of January 31, 2022. 

⁷ Source: Refinitiv Global Convertibles Focus Index. Data as of January 31, 2022.  

⁸ Source: S&P/LSTA Leveraged Loan Index.  Data as of January 31, 2022. 

⁹ Source: Bloomberg, as of January 31, 2022.

RISK CONSIDERATIONS

Diversification neither assures a profit nor guarantees against loss in a declining market.

There is no assurance that a portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the portfolio will decline and that the value of portfolio shares may therefore be less than what you paid for them. Market values can change daily due to economic and other events (e.g. natural disasters, health crises, terrorism, conflicts and social unrest) that affect markets, countries, companies or governments. It is difficult to predict the timing, duration, and potential adverse effects (e.g. portfolio liquidity) of events. Accordingly, you can lose money investing in a portfolio. Fixed-income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In a rising interest-rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. In a declining interest-rate environment, the portfolio may generate less income. Longer-term securities may be more sensitive to interest rate changes. Certain U.S. government securities purchased by the strategy, such as those issued by Fannie Mae and Freddie Mac, are not backed by the full faith and credit of the U.S. It is possible that these issuers will not have the funds to meet their payment obligations in the future. Public bank loans are subject to liquidity risk and the credit risks of lower-rated securities. High-yield securities (junk bonds) are lower-rated securities that may have a higher degree of credit and liquidity risk. Sovereign debt securities are subject to default risk. Mortgage- and asset-backed securities are sensitive to early prepayment risk and a higher risk of default, and may be hard to value and difficult to sell (liquidity risk). They are also subject to credit, market and interest rate risks. The currency market is highly volatile. Prices in these markets are influenced by, among other things, changing supply and demand for a particular currency; trade; fiscal, money and domestic or foreign exchange control programs and policies; and changes in domestic and foreign interest rates. Investments in foreign markets entail special risks such as currency, political, economic and market risks. The risks of investing in emerging market countries are greater than the risks generally associated with foreign investments. Derivative instruments may disproportionately increase losses and have a significant impact on performance. They also may be subject to counterparty, liquidity, valuation, and correlation and market risks. Restricted and illiquid securities may be more difficult to sell and value than publicly traded securities (liquidity risk). Due to the possibility that prepayments will alter the cash flows on collateralized mortgage obligations (CMOs), it is not possible to determine in advance their final maturity date or average life. In addition, if the collateral securing the CMOs or any third-party guarantees are insufficient to make payments, the portfolio could sustain a loss.