But there is a bright spot to consider: With yields now higher, we believe bonds are attractive again.
In our latest Cyclical Outlook, Prevailing Under Pressure, 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 analyse 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.
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.
Further, in addition to higher income potential, yields are high enough to provide the potential for capital gains in the event of weaker-than-expected growth and inflation outcomes or in the event of more pronounced equity market weakness. We expect that more normal negative correlations between high quality bonds and equities will re-assert themselves, thus improving the hedging characteristics of quality core bonds, which generally should rise in value when equities fall. Also, the higher yields offered in bond markets today could help compensate those who choose to wait out this period of uncertainty and potentially higher volatility.
Still, caution is warranted, and if inflation is more sticky than we expect, central banks could be forced to hike rates by more than is priced in currently, and if recessions are as shallow as we expect, then policymakers may be slow to cut policy rates to boost growth, given the high inflation starting point.
Thus, in core fixed income portfolios, this is an environment where we are prepared to take the active and deliberate decision to reduce risk across a range of risk factors and to keep some dry powder (i.e., maintain liquidity). Liquidity management is always important but is especially important in a difficult and highly uncertain market environment. In line with our secular outlook, we will look to maintain portfolios that will be resilient across a range of economic, geopolitical, and market outcomes.
We share our views on other assets in the full Cyclical Outlook, but here we make one final point: We believe the anticipated real economic and financial market volatility will lead to attractive opportunities for investors with patience and fresh capital. The gap between private and public asset valuations remains extreme, but as private markets adjust and challenges become apparent across the corporate credit and real estate space there should arise opportunities to potentially generate outsize returns. This is one of our highest conviction views.
For more details on our outlook for the global economy and investment implications over the next year, read the full Cyclical Outlook here.
This post is funded by PIMCO
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