Many investors are on the fence about re-entering the badly battered bond market when the bottom may be near. The smart ones will want to enter the market well before interest rates hit their peak, says Michael Gitlin, partner and head of fixed income at Capital Group. “Those who systematically get into bonds roughly six months before and after the peak can count on 5 to 7 per cent returns,” he argues.
Global bond traders have been waiting for a bottom in the market for months. All-important for that bottom is the interest rate path of the Federal Reserve (photo). If the economic outlook worsens significantly, the US central bank, with all western central banks in its wake, will not be able to raise interest rates further.
‘Fed pivot’
Dollar-cost-averaging - systematically, periodically investing in assets regardless of exchange rates - is, as far as US asset manager Capital Group is concerned, the best strategy to anticipate this turn in interest rate policy, the so-called “Fed pivot”.
So far this year, tightening central banks have triggered historically deep falls in bond markets. The Bloomberg Aggregate Bond Index, the most widely used benchmark for the broad, diversified investment-grade US bond market, shows a negative performance of over 14 per cent this year.
The market forecasts that the federal funds rate, the main official US interest rate, will peak between 4.5 and 4.75 per cent in March 2023. This is likely to end the declines in bond markets, as newly issued bonds will no longer offer a better coupon than outstanding bonds from then on.
Bond investors wise enough to unleash a dollar-cost-averaging strategy on the bond market six months before the “pivot” will be looking at “very interesting annualised returns, over the next few years,” said Gitlin. “Especially with the elevated interest rates.”
Neutralising duration
“We are the first to neutralise our underweight in duration,” Gitlin explained when asked what strategic choices Capital Group makes within its fixed-income portfolio ahead of the interest rate peak.
“For a global portfolio like ours, it is also important to diversify across sectors and regions. We find Latin America particularly interesting at the moment. Inflation is not a new phenomenon there. Central banks reacted quickly there with interest rate hikes, yields look attractive, and the currency is cheap.”
Gitlin believes that over the next 18 to 24 months, all the withdrawals will flow back into the market, and even more. “You can put together good bond portfolios right now that will yield 5 to 7 per cent over the next few years.”
Gitlin said it is wise to assume that the market knows how to price the interest rate spike well, but the market is not sacrosanct. “Mind you, the market is also pricing in that the Fed will be able to cut interest rates again in 2023. We disagree with that. Inflation will still be far too high above the Fed’s inflation target even in 2023,” Gitlin told Capital Group’s media event last week.
‘Looks like the 1970s’
Capital Group’s economists anticipate a regime that will be characterised by persistently high inflation and higher nominal interest rates. “Such an economic picture is similar to the 1970s,” says Robert Lind, economist at the US asset manager.
Then, too, inflation was the main driver of the very aggressive action of central banks worldwide, with the Fed leading the way. “Central banks now seem to understand that they have lost their grip on inflation, and so they are likely to be much more readily willing to move very quickly to raise interest rates, with all the implications for economic growth that that implies,” Lind said.
Discussions within the team of economists, Lind said, focus on a relatively narrow set of fundamental measures that are the main drivers of global growth.
To begin with, supply expectations from manufacturing purchasing managers indicate economic contraction, according to the Purchase Managers Index (PMI). The index points to a deterioration in output in the coming months due to a decline in global trade. This is partly caused by continued high costs of living, and increasing economic uncertainty.
One factor adding to the ominous long-term developments in the global economy are structural changes in commodity price dynamics, Lind said.
“The supply formation is completely different now. We currently have two opposing forces in this sector. On the one hand, prices are being pushed up due to geopolitical tensions, and on the other, a slowdown in the economy is pushing in the opposite direction. Add to that a possible end to globalisation, and you are looking at an unsavoury future. Globalisation is clearly at a tipping point and will not return as we have known it,” Lind concluded.
This article originally appeared in Dutch on InvestmentOfficer.nl.