What the second half of 2022 has in store for markets, inflation and high yield bonds

AXA IM, CIO, Core Investments, Chris Iggo

The first half of 2022 was difficult for all markets. Total returns in both fixed income and equities have been the worst since the early 1970s.

Rising inflation, central banks responding to the war in Ukraine and ongoing supply issues have all impacted market performance and investor sentiment.

Inflation remains high, exacerbating a still challenging situation. We are looking at additional interest rate increases in the US, Europe and beyond in the coming months. For now, the Ukraine crisis shows no sign of improving.

But there are some positive signs amid the outlook. We have witnessed a peak in government bond yields in recent weeks, and the market seems to have settled on where it expects policy rates to peak in this current cycle - just above 3% in the US and about 1.5% in Europe.

However, expectations can change; there is a risk that inflation numbers will continue to surprise on the upside, meaning central banks will need to do even more.

But for now, rate expectations have stabilised, and bond yields come down somewhat from highs seen in early June.

Average bond prices have fallen substantially since the end of last year, yields are higher – corporate and high yield, as well as government bonds – giving investors the opportunity to look at potential new fixed income market entry points.

We have also seen a significant derating of equity markets, linked closely with the rise in bond yields. Previously expensive parts of the equity market – high-quality high growth in particular – have seen price/earnings multiples fall significantly, back to levels which prevailed before the COVID-19 pandemic.

The global economy is expected to slow over the next few quarters, and as a result, right now all eyes are on corporate earnings, as an indicator of what to expect next year.

Across both fixed income and equities, our own assessments – based on valuations and other technical factors – have improved significantly. Our portfolio managers do see better value across markets but clearly the economic outlook remains very challenging.

AXA Group Chief Economist and AXA IM Head of Research, Gilles Moëc

The outlook for the second half of 2022 is not particularly cheerful – and our forecasts are below consensus. We are expecting US GDP growth of 1.2% for 2023, against a consensus of 1.8% and Euro Area growth of 0.7% compared to the consensus of 1.5%.

We see five main headwinds blowing against economies. First, the significant inflation spike, which is eroding purchasing power everywhere. We have seen some improvement recently in oil, which will benefit the US particularly, but this is offset by additional pressure on gas, which is problematic for the Euro Area.

Second, weak Chinese demand – regardless of whether we see additional outbreaks of COVID-19. The Chinese authorities do not seem to want to stimulate domestic demand too much as they are worried it could stoke domestic financial imbalances, so they are in reactive mode.

Third, the end of the big fiscal push in the US – and if the Democrats lose the mid-term elections, we could even have restrictive fiscal policy in 2023. Fourth, the end of fiscal support for households, other than the most vulnerable – particularly in Europe. Up to now governments have provided quite a lot of protection to deal with the current inflation spike but they are coming to the end of that capacity.

Fifth, as central banks have reacted to rising inflation, financial conditions have tightened. We can see this in the refinancing rates of corporates, and in the recent European Central Bank lending survey, which showed banks are tightening credit standards for households and businesses.

This will have an impact in coming few months and is already started to be reflected in economic surveys such as Purchasing Managers’ Indices.

The question is whether this deterioration in data flow will convince central banks to tone down their hawkish rhetoric, which would provide the market with little bit of breathing space in the coming months. My expectation is that we are not there yet.

In the US, we are starting to see the beginning of normalisation of consumption, as people are less keen to draw on the excess savings built during the pandemic, and a normalisation of the labour market, but not enough yet for the Federal Reserve to change its stance. The Fed will need to see greater signals that inflation is under control before it moves away from its hawkish rhetoric.

We expect central banks globally will continue to hike and I expect it will only be towards the very end of the year and start of 2023 when that will start to change.

AXA IM Head of Sovereign, Inflation and FX, Fixed Income, Jonathan Baltora

We have been going through several waves of inflation – as was the case with COVID-19 – but the market, and economists, do expect inflation to be transitory.

Our quarterly inflation survey of economists show they think peak inflation in the US is two months ahead of us, while in Europe it is three or four months ahead, at close to 9% and slightly below 10% respectively.

However, inflation has continued to surprise on the upside. The consensus had been expecting a sharp deceleration after the peak but is now expecting inflation to move down quite slowly, so we may have a plateau of elevated inflation into the year end.

And the longer we have entrenched inflation, the harder it will be to get rid of it. But a survey of economists shows that inflation is expected to be transitory. It shows inflation is expected to be back below 2% in the Euro area and in the US in 2024. Other indicators also show that the market is also pricing inflation to be transitory and is not incorporating any significant upside risk from inflation from 2024.

The main investment conclusion is that I believe long-term inflation breakevens - the difference between the nominal yield on a fixed-rate investment and the real yield on an inflation-linked bond - are 20 to 40 basis points too low. As such, they are not as attractive as they used to be, especially compared to other inflation-linked bond strategies.

Short-maturity inflation-linked bonds could potentially provide investors with a significant buffer against rising interest rates, and we expect the carry to remain extremely positive, due to higher real interest rates since the start of this year and solid inflation indexation going forward.

The income provided by longer-maturity inflation-linked bond is potentially very attractive and could help investors weather higher real interest rates. Longer-maturity inflation-linked bonds are potentially exposed to more volatility through greater sensitivity to interest rates but could also offer greater opportunities in a stagflation scenario.

We see three key drivers for inflation over the medium term – more sustainable fiscal spending, the ongoing debate around deglobalisation, and the green revolution. More and more investors are integrating investment-linked bonds into their long-term strategic asset allocation, and I believe this will continue to be the case.

AXA IM, Senior US High Yield Portfolio Manager, Peter Vecchio

There are several uncertainties and headwinds ahead, including inflation and hawkish central banks, potentially pushing us into a recessionary environment – and market volatility is likely to continue.

However, following a prolonged sell-off, in our view we are seeing more attractive valuations in high yield than we have seen in a long time. We believe the sell-off has reset valuations and created much more potentially attractive opportunities, for instance in the high-quality BB credit space.

The default rate is currently 0.75%, just off the all-time low of 0.22% recorded only a couple of months ago. While this is unsustainable in the longer term, even if we move back towards, or above, the longer-term historical average of 3.3% to 3.4%, this would still be a relatively benign credit environment.

Corporate balance sheet health remains fairly strong, earnings have recovered from their COVID-19 lows, and companies have ample liquidity with no looming walls of maturity.

We have seen record amounts of primary market activity over the last couple of years, and most proceeds have been used for refinancing, allowing companies to push out their maturity profile. As such I believe that companies have a rather ample cushion to weather this inflationary and potentially recessionary environment.

Where we have the most confidence and conviction currently is in short duration strategies, as these tend to be defensive, with lower volatility, but still with the potential to perform well. We have only seen two other brief periods since the global financial crisis where short duration yields were higher than they are today – during the 2011 US downgrade and the onset of the pandemic in 2020. Likewise, there has only been one other period with a lower average dollar price – again during the 2020 pandemic. 

Short duration strategies have tended to be resilient and generally bounce back quickly. We remain confident that forward returns over the next six to 12 months will be solidly positive as there is always the pull back to par or back to the call price for these shorter-duration bonds. 

If inflation remains high, and even if we go into a recession, we believe short duration bonds could potentially weather this environment, offering potential protection on the downside but still capturing a significant percentage of the upside going forward.