Don’t Look Back in Anger

The 1990's era band Oasis preached "don't look back in anger". With that wisdom in hand, the less said about 2022 the better! Thus, this quick review of last year in fixed income markets will employ, as much as possible, the "a picture is worth 1000 words" approach, letting a few key charts and graphs do the talking.

Returns:

Source: FTSE/Russell; Bloomberg

After the worst 9-month period on record, North American fixed income markets finally found some much-needed footing in Q4. While the stabilization in returns still left the overall performance in 2022 as one for the history books and thus one to forget, it does point to the potential for better times ahead. For the month, quarter and year, the Universe Canadian fixed income market returned -1.65%, 0.10% and -11.69%, respectively. South of the border, the US market returned -0.42%, 1.78% and -13.16%, respectively. While one quarter is certainly not a trend, the better performance in Q4 is hopefully a sign that the worst is behind us.

Inflation:

Source: FTSE/Russell; Bloomberg

Investors' hopes for "peak inflation" appear to be getting some validation in the recent data. US headline CPI peaked in June at 9.1% and remained above 8% through September. Over the fourth quarter however, this measure has moderated to end the year at 6.5%. While still well above the Federal Reserve’s comfort zone, the 6-month annualized rate is running at only 1.8%, pointing to continued declines going forward. In terms of the more closely watched "Core" inflation, US Core CPI peaked at 6.6% in September. It has also shown some moderation over the final quarter of the year, falling to 5.7% in December. One of the key components within the Core inflation that is keeping upward pressure on this measure is shelter prices. This is a well-known "lagging" indicator, and with market rents falling sharply of late, shelter prices are expected to moderate in 2023, bring down Core CPI with them.

Source: Zillow; Bloomberg

Monetary Policy Expectations:

Source: Bloomberg

The improvement in the inflation outlook has helped to improve the market's expectations for the path of monetary policy. After the dramatic repricing higher in policy expectations in Q3, the market has become increasing optimistic that we are nearing the end of the tightening cycle. While a Fed "pivot" or policy reversal still looks to be a fair way down the road in our opinion, a slowing in the pace and nearing of a "pause" in tightening has buoyed investor sentiment. Granted we have seen this "movie" a few times before over the past year, when "pivot" hopes, combined with poor investor sentiment and short positioning fueled meaningful countertrend rallies in both yields and risk assets, only for consistent hawkish messaging from the Fed to ultimately dampen the mood. This may prove to be the case again in early 2023, but with far more rate hikes behind us than in front of us, market sentiment appears to have improved markedly over the past quarter. Thus, we are more constructive as we enter the new year. That said, we are not yet "throwing caution to the wind" completely. As the chart above highlights, investors are now expecting almost 3, 25-bps policy rate cuts in the 2nd half of 2023 despite central bank guidance to the contrary. As mentioned, the Federal Reserve has on a number of occasions, pushed back when the market's expectations have deviated too far from their internal expected policy path. The market maybe getting a little too far ahead of itself, as evidenced by the UST 10-year yield near 3.5%, yet the policy rate is still expected to peak near 5%. Therefore, we are still currently neutral with respect to the interest-rate risk in our funds. However, we will likely look to use any further backup in yields to add duration given the cloudy forecast for growth.

Yields:

Source: Bloomberg

At its peak of 4.24% on October 24th, the UST 10-year had risen 273 bps YTD. Thankfully, despite ongoing elevated volatility, yields found some support in Q4. As discussed, inflation measures look to have peaked, and many forward-looking components of these gauges are pointing to further declines. With economic activity already slowing and recession risks elevated, the macroeconomic environment has become more supportive for bond yields. Combined with the repricing higher in yields that has taken place over the past year, we believe the outlook for fixed income assets, particularly government bonds, has notably improved. Yields having risen to levels not seen since the GFC and with expectations for a meaningful slowdown in growth and inflation, the return potential for bonds is looking more attractive than it has in over a decade. That said, we are cognizant that monetary policy expectations, one of the key drivers of short-term movements in yields, have become somewhat overly optimistic. Therefore, we will be looking for more attractive entry points to add further duration.

Credit Spreads:

Source: FTSE/Russell; Bloomberg

After widening for most of the year, corporate credit spreads look to have put in a near-term peak early November, benefitting from a broader stabilizing in risk assets and a supportive demand/supply backdrop. This allowed investment-grade corporate bonds to outperform government bonds in Q4. We believe that both macroeconomic and credit fundamentals will remain constructive over the next 1-2 quarters, with overall economic activity and earnings still relatively well supported, albeit on a weakening trend. However, as we move through 2023, growth is expected to moderate, perhaps sharply – leading indicators such as global PMIs have rolled over materially, yield curves have flattened significantly, and margins and earnings will face greater headwinds going forward. To date, top-line growth has been supported by companies' exercising pricing power in an inflationary environment. It will be much more difficult to repeat those price increases on an ongoing basis, thus putting downward pressure on revenue and earnings growth next year. That said, corporate and consumer balance sheets are healthy, and the labour market remains strong. So while the fundamental environment is expected to deteriorate, it is coming off a strong base. Corporate credit valuations have cheapened over the past year, although they have improved in recent weeks. The combination of higher underlying government yields and wider credit spreads have pushed up corporate bond yields to historically attractive levels. We have used these higher yields as an opportunity to add to our credit exposures in our funds. However, given ongoing recession risks, we continue to exercise caution with respect to our credit market exposures, focusing on shorter-term, high-quality issuers. As we have pointed out in the past, risk rallies have not been driven nor confirmed by any improvement in the macro fundamentals. Housing, LEIs (leading economic indicators), business and consumer surveys, just to name a few, typically lead the economic cycle, and they are simply not yet showing meaningful signs of stabilization. Not to mention that the full weight of the monetary tightening to date has yet to be fully felt by the economy – and while close to the end, central banks still have some work to do. Therefore, sustained optimism for risk assets on our part will require some positive signals on the macro front. But in the near-term, sentiment and momentum are expected to drive positive relative returns in credit.

Rates positioning: (i) neutral duration; (ii) neutral yield curve exposures; (iii) overweight Cdn prime residential mortgages; (iv) overweight RRB's; (v) overweight Canada but reducing that position on opportunity

Credit positioning: (i) small overweight credit; (ii) maintain a quality bias in favour of IG over HY, and more defensive credits within IG; (iii) overweight Cdn corporates, underweight US.