Bonds back better?
If economists are right, 2022 will be the second year of well above trend nominal GDP growth. As long as central banks don’t go crazy, this is good news for markets (the risks still being that they do). On the upside, a bigger pie means there is more for corporates and households. I don’t see the equity bull market being over as a result. But things could get more interesting in bond markets too, especially if a lot of bad news on rates or credit gets priced in.
In the US, money (nominal) GDP is likely to expand by more than 10% this year. On the basis of consensus forecasts, 2022 will see a growth rate of more than 7%. This is well above recent average growth. Since 1991 the annualised average growth in money GDP has been 4.5%. In per capital terms this means well above average increases in incomes for Americans. Per capita GDP has grown on average by 3.5% but will have gone up by around 9% this year and by 6% next year. Of course, neither the rise in national income nor the increases in wealth that have been generated by rising stock and real estate markets are evenly distributed. Nevertheless, with rising employment and wages, Americans should be feeling a lot wealthier as they emerge from the pandemic.
Higher rates but still good to borrow
Even as nominal GDP growth slows in 2022 and 2023, the pace of growth is likely to be above the level of interest rates. There has been a loose relationship between the level of long-term bond yields and nominal GDP growth in the past but the gap has widened in recent years because of financial repression. If the Federal Reserve does wind-down its bond buying and nominal growth remains strong over 2022-2023, bond yields should be higher than they are today. But the environment will remain supportive for debtors on the view that potential returns generated by stronger nominal growth will be higher than the cost of servicing.
For the corporate sector, revenues are strong. Even with the supply issues, the Q3 earnings season has delivered better results than feared. With 117 S&P500 companies having reported at the time of writing, the net surprise on sales was 2% but the net surprise on earnings was 13%. Financials, technology and healthcare have driven this so far but for the market as a whole this has been sufficient to generate new highs on the index.
Credit to credit
Our fixed income teams have continued to like credit – corporate bonds – from a fundamental and technical point of view. The weakness in the investment argument has been valuations. Today, valuations are more attractive. If we take the US investment grade market, outright yields are now close to 2.3% at the index level – close to the highest of the year. The US is more attractive than European credit given a more than 175 basis points yield advantage which more than compensates for the cost of hedging US exposure back to Euro. With Treasury yields going higher, the yield on US credit will become even more attractive. Indeed, it is a yield play because the credit spread has barely moved. But why not look to allocate more to fixed income now that yields are higher.
Higher yields and a more fluid outlook for central bank policy than has been the case for some time provides opportunities for active fixed income investors. Things are moving again relative to during the middle of this year when it looked like someone had turned volatility off. Don’t get me wrong, yields are still low but the fact that fixed income markets are able to respond to news on inflation, central banks and corporate sector developments support an active exposure to bonds. For the brave, there are parts of the emerging market debt complex that provide very high yields. Asian fixed income, for example, which is still reeling from the issues surrounding borrowers from the Chinese property sector. Asian high yield offers more than 7.5%. This clearly reflects the risk of contagion but also signals strong total returns going forward. The yield on the JP Morgan Asian corporate high yield bond index recently went above 8%. The last four occasions on when this happened over the last decade were followed by periods of very strong returns.
Consecutive losses are unusual
This year has not been good for fixed income investors. Take note though that two consecutive years of negative return are very rare. The UK gilt market is a good example. Year-to-date, total returns are -7.6%. The last time there was a full year of negative returns was in 2013 (taper tantrum year). That was followed by a 14.7% gain in 2014. The global investment grade credit market delivered negative returns in 2018 as the world economy slowed in response to higher US rates, but 2019 saw returns come roaring back.
It may be premature to become bullish on fixed income but in some areas a lot of bad news on rates (UK) or credit (Asia) has already become priced. The overall total return from the US Treasury market index is negative so far this year and not far off the outcome delivered in 2013 when the market rapidly priced in Fed tapering. Inflation is more of a concern today and central banks globally will probably need to move to a less accommodative stance, but markets will overshoot in terms of expectations. It maybe has not happened in the US or the Euro Area yet but equally, central banks are aware of the risks of moving too much. I have a feeling 2022 could be a good year for fixed income returns.
On 7 November I will be attending the investment conference that is running parallel to COP26. Investors should be focussed on what is expected from the meeting of world leaders and, I guess, it could be quite easy to be disappointed. At a minimum there needs to be more countries delivering their updated Nationally Determined Contributions (NDCs) to the fight against climate change, there needs to be real commitment to helping developing countries and there needs to be agreement on some of the technical features of more collaborative use of carbon market mechanisms to achieve real, permanent, reductions in C02 emissions. I am not sure markets will react to whatever noise comes out of Glasgow but there is a risk that both growth and inflation expectations could be impacted by what is or is not agreed. It’s important that investors see policy moving in the right direction, because we are. It will be great to be in Glasgow too.