Global fixed income valuations have been reset

2022 was a terrible year for all asset classes, and fixed income was no exception. However, the good news is that, following last year’s losses and the long global interest rate hiking cycle, considerable value has been brought back to global bond markets. In fact, for the first time in a decade, we believe that bond investors are being well paid to take both interest rate and credit risk.

Investment-grade corporate bonds, in particular, should be well placed to navigate the more uncertain economic environment. Through their separate interest rate and credit components, they offer an attractive combination of yield, diversification, and resilience to perform in a variety of market conditions.

High inflation has been the key driver of bond losses; and while it has started to fall in most regions (with the possible exception of the UK), the sharp deceleration in money supply now being experienced thanks to central banks’ tighter monetary policies should continue to push inflation lower. We’re by no means out of the woods, but we do seem to be past the worst, and the market is now predicting interest and inflation rates in most countries will come down gradually over the next 12 months.

However, this prediction is based on an average of two very different economic scenarios that could play out. One is where the US economy keeps growing and interest rates rise to, say, 6% or beyond for an extended period (the “higher for longer” view); the other is where we see further banking problems and a steep recession causing the Fed to slash rates back towards 2%.

My view is that we could be due for a big growth slowdown. This is because when central banks raise rates as aggressively as they have, things tend to break. And we’re seeing the early signs of stress following April’s string of bank failures, which has fundamentally changed the narrative. We at M&G were previously in the “higher for longer” camp, but we now believe that the Fed will need to start applying the brakes on its long hiking cycle, as borne out by its decision to keep rates unchanged in June.

Identifying opportunities in government bonds

For many governments inflation has been extremely beneficial in reducing debt/GDP ratios, and these are the countries we’re focusing on. We also look to identify countries where we think interest rates and inflation will come down the quickest. In developed economies, the US is furthest down the road in this process. Indeed, we’re now seeing a collapse in US money supply, and this normally leads to falling inflation.

We’ve also seen a sharp inversion in the US yield curve – where long-term yields are lower than short-term yields – which has historically been a very reliable predictor of a US recession. 

Given that the Fed recently paused its rate hiking agenda, and our sense that this is likely to continue, long-term US Treasuries remain our preferred investments in core government bond markets.  The European Central Bank, in contrast, will probably need to hike for a little longer, given that core inflation remains elevated.  As a result, we’re more cautious about European government bonds.

Looking further afield, we continue to see value in emerging market (EM) bonds as EM countries generally offer the strongest long-term growth potential and benefit from young populations and low debt/GDP ratios. Valuations also look attractive, with emerging market bonds offering yields well above inflation. But it’s important to be very selective.

EM central banks generally acted ahead of the curve in the current rising rate cycle, taking the opportunity to hike rates early. This means their inflation should also start to come down quite rapidly and provide a further tailwind to the asset class. While not without risks, we think these risks are more than reflected in EM bond valuations – we’re currently finding attractive opportunities in several areas, especially Latin America and Southeast Asia.

Investors will find these views reflected in the positioning of the M&G Global Balanced, Global Inflation Plus and Global Bond Funds (and their rand-feeders), where we prefer long-dated US Treasuries and UK gilts, investment-grade corporate bonds and selected emerging market government bonds. In the current conditions, diversification is more important than ever, and M&G’s global funds could offer that much-needed diversification.   

For more information or to invest, please contact our Client Services team on 0860 105 775 or email us at info@mandg.co.za.