17 Jun 2022
While the UK recently celebrated the Queen’s Platinum Jubilee, there has been less to be jubilant about in fixed income following a very challenging period in markets. Against this backdrop, Fidelity Strategic Bond Fund co-manager Claudio Ferrarese discusses whether we could be approaching an inflection point in yields, highlighting where we now see investment potential across rates and credit markets.
We have recently seen one of the worst periods in bond market history as investors grappled with several headwinds. Q1 and Q2 so far have continued the established themes of high volatility, high inflation (although that has probably peaked in the US at least), higher yields as central banks become ever more panicked about inflation, and lower real growth expectations.
US growth data has definitely taken a turn for the worse in the last few weeks. The ISMs driving a notable tick down in what had otherwise been a strong run of positive data surprises year-to-date. Meanwhile, in China, incoming data on Shanghai factory closures and container ship sailings and lockdowns in Beijing look ominous for the global economy, as does rock bottom consumer confidence and squeezed disposable incomes across the developed world.
Purchasing Managers Index (PMI) data makes for difficult reading
.png)
Source: Fidelity International, Bloomberg, 1 June 2022.
We are now at an inflection point in yields, where the growth outlook has deteriorated enough for central banks to start stepping away from the rapid tightening cycle that they had recently committed to. Recession is probably a base case here, but we wouldn’t want to rule out a ‘soft landing’ completely and, again, think that the US has the best chance there.
Credit looks cheap for a soft landing but expensive if a recession happens: getting this right will be key. The Fed put location is unknown, but we think today’s central banks don’t have the strength of conviction of their 1980s and 1990s forbears, and in fact a convincing ‘off ramp’ story is already developing for them. Peaking year-on-year inflation (the US almost certainly peaked in March, in year-on-year terms) could be a signpost for this.
Rates markets on the whole don’t seem ready for a regime change quite yet and we expect the flattening trend to continue. The ECB are in an even more difficult situation, with persistent inflationary surprises from energy and food prices, set alongside downside growth risks from the war in Ukraine and still a fair amount of labour market slack. However, the central bank is likely to pursue an aggressive hiking strategy while it can, not least to move away from negative policy rates.
In terms of recent portfolio moves, we have topped up our duration exposure this month, with increases in Gilt duration. Yields have increased as markets have priced in aggressive central bank tightening, but we are still retaining more room to add duration if yields do keep rising. The deteriorating growth outlook and more balanced central bank activity should allow government bonds to resume their traditional hedge against riskier assets.
On the credit side, we continue to keep exposure to high yield on the low side of our historical range, primarily using derivatives, which was the hedge initiated over the course of Q1. The deterioration in growth data continue to make us cautious on high yield as its relative outperformance in the credit sell-off year-to-date has made it relatively less attractive. On the other hand, our investment grade exposure has risen given the valuations on offer, especially in EUR.
In times of market volatility, the fund’s well established ESG process should continue to act as a strong foundation - for instance, as geopolitical changes have led others to remove Russian government bonds from portfolios and bring back nuclear power. Europe’s energy supply challenges pose an interesting question for sustainable-focused investors and we believe we are in a strong position to capitalise on the rising demand for renewable energy sources.
Important information
This information is for investment professionals only and should not be relied upon by private investors. Past performance is not a reliable indicator of future returns. Investors should note that the views expressed may no longer be current and may have already been acted upon. Changes in currency exchange rates may affect the value of investments in overseas markets. The value of bonds is influenced by movements in interest rates and bond yields. If interest rates and so bond yields rise, bond prices tend to fall, and vice versa. The price of bonds with a longer lifetime until maturity is generally more sensitive to interest rate movements than those with a shorter lifetime to maturity. The risk of default is based on the issuers ability to make interest payments and to repay the loan at maturity. Default risk may therefore vary between government issuers as well as between different corporate issuers. Due to the greater possibility of default, an investment in a corporate bond is generally less secure than an investment in government bonds. Reference in this document to specific securities should not be interpreted as a recommendation to buy or sell these securities and is only included for illustration purposes.