Economics and markets
September 20, 2022
The 2022 bond market so far has been the worst in history. Surprisingly high inflation spurred the Federal Reserve into rapidly hiking interest rates, and broad capital losses followed for bond markets. Do active portfolio managers see hope for fixed income investors anytime soon? Two managers with Vanguard’s active bond funds—Daniel Shaykevich, who focuses on credit and multisector portfolios, and John Madziyire, who oversees rates strategy—offer their perspectives.
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Madziyire: No one has predicted inflation well. We had COVID, then the stimulus. Now we’re watching commodity and supply-chain disruptions, for which inflation momentum is on the downside.
But we’re more focused on core inflation, where the numbers are still rising. Services inflation is increasing even as goods prices are dropping. That’s because the labor market is so tight. Then there is the property market, where rent increases have been crazy high. But the data are not straightforward given all the disruption that has happened.
Shaykevich: There are stronger longer-term forces at play than many people realize. We’re in a new inflation regime. It’s changed because globalization has largely run its course. For example, China has run out of rural workers to bring into factories.
Geopolitics is another obstacle to further global economic integration. Energy costs in the aftermath of Russia’s invasion of Ukraine will matter. Europe will need to import more liquid natural gas, and that’s expensive. The move to diversify away from carbon fuels will be inflationary in the medium term, as we’re moving away from existing, cheaper generation.
Another contributor to inflation is labor costs: Workers now have a lot more negotiating power, especially in the U.S. All of these factors will make it hard to get to 2% inflation anytime soon.
Madziyire: We don’t agree with the market pricing. The difference between headline and core personal consumption expenditures inflation is usually about 50 basis points, so an expectation of 2.4% would imply core inflation of about 2.0% two years from now. That’s going to be hard to achieve.
Our active team is taking a strategic view. If you think about it, the Fed and other central banks will have to pivot at some point. You typically start to see these turns occur two hikes, or two meetings, before central banks stop raising rates. We think we’re getting close to this point, maybe by the end of this year or early next year, when the Fed will be done with the hiking cycle. So we’re looking at steepener trades—buying the shorter end of the curve and selling the long.
Shaykevich: I have a hard time ruling out a reacceleration of the U.S. economy. What happens if you have more growth into a market with full employment, with high demand for energy and commodities? You could have inflationary pressures that do not come down as people expect.
Considering both upside risks to rates and downside risks to growth, we have reduced our credit position to a more neutral level. With sufficient dry powder, you can be in a good position to take advantage of opportunities.
The markets have priced in certain terminal rates in the federal funds rate. But if economic data force the market to contemplate the terminal rate at higher than 4%, credit spreads would likely widen with lower-rated credit getting hit disproportionately hard. It doesn’t mean the terminal rate has to go to 5%, but the market considering that possibility would create stress.
Madziyire: The market had been expecting a Fed that would raise rates so much that it caused a recession, then cut rates by July 2023. That’s an aggressive stance.
There has been a lot of volatility in the market, meaning there are more opportunities for active management. The market has moved a lot in the past few months, so we’ve been more tactical than usual.
Shaykevich: As investors, we work to identify any disconnect between our expectations and market pricing. Also, any good market participant understands where there may be bigger upside in one scenario or smaller downside in another. You have trades that you get right where you make more money than expected, or trades you get wrong but you lose less.
Our goal is not to always know what’s going to happen. It’s to understand the risk-reward profile of different strategies and to identify the best opportunity, whether it is in credit, mortgages, high yield, or even parts of the curve.
Shaykevich: In emerging markets (EM), we still see opportunity in the middle-quality bonds that compose the bulk of our EM holdings. These bonds offer wide enough spread levels to justify the risk taken.
Traditionally, a global economic slowdown would hurt EM, as they are growth-sensitive countries. Today though, we think pricing already reflects lower global growth. We have to consider the risk of falling commodity prices on EM commodity exporters. Exporters would get hurt, but EM commodity importers would benefit, and given elevated inflation levels, some moderation in commodity prices is positive for economic stability more broadly. By avoiding countries that are both economically weaker and dependent on energy exports, we’re helping safeguard portfolios from the impact of slower growth.
Madziyire: When interest rates are going up, you want to lean into short-maturity bond funds to reduce your duration risk. But when interest rates are coming down, you want to be in longer-maturity bond funds to increase your duration risk. Right now, the interest rate yield curve is flat, so you get roughly the same yield in short- or long-maturity bonds and bond funds; it makes sense to own short-duration bond funds if you don’t want to take a view on the direction of interest rates. But if you think we are near the end of the interest rate hikes, and if you’re comfortable with some interest rate risk, then you may want to go further out on the curve.
Madziyire: Our belief is that bonds are back. The Bloomberg U.S. Treasury Index is down 10.0% for the year through August 31; the Bloomberg U.S. Long Government/Credit Index is down 22.5% in the same time period. Those are equity-like negative returns. But the downside from here should be pretty limited. Even if the Fed raises rates until we get a recession, it will have to start cutting again, and your fixed income returns will start coming back.
It has been painful to be long on bonds this year. But because of the higher yields available now, your risks are asymmetrical: There’s likely more upside than downside. Even if rates go up a bit, coupon payments can absorb some of that effect on bottom-line results. As we get close to the end of the hike cycle, a lot of the pain is going to be in the past. Even if we do get into a recession, equity markets may go down, and your bonds should be the hedge that historically they’ve been.
Investors who hang in there are probably going to be glad they did.
All investing is subject to risk, including possible loss of principal. Diversification does not ensure a profit or protect against a loss. Past performance is no guarantee of future results.
Bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer's ability to make payments.
Investments in bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk. These risks are especially high in emerging markets.