At year-end, it’s natural for investors to start considering outlooks and allocations for the new year. We recently published our outlook for markets, with a key message that the new year will likely bring more volatility and more complicated fixed income markets. Even as we were discussing these ideas, November was shaping up to be a preview of what we think investors should expect in the coming year—there are discernible tremors in credit and currency markets that may be forewarnings of volatility to come.
On the surface, November may have appeared to be another month of quiet, range-bound fixed income markets. U.S. and German 10-year yields are at 1.65% and -0.23%, respectively, well within the ranges we have seen all year. Likewise, investment grade, high yield credit and higher quality emerging market spreads across global markets remain quite low and stable.
However, several underlying trends are developing that suggest to us that the transition to more volatile and two-way fixed income markets is starting.
First, we are observing an acceleration in expectations for central bank rate hikes. One reason that nominal interest rates have generally been stable is that the markets have been pricing faster hikes by the Federal Reserve, European Central Bank and Bank of England, for example, but not a higher terminal rate. That appears to be changing, with markets beginning to price a modestly longer cycle with a higher ending rate.
We think this is largely a recognition that both above-trend growth and above-trend inflation are here to stay. On the growth side, a combination of continuing fiscal spending, demand deferral for goods, and increasing spending on services is a recipe for continued above-trend growth in the Western economies. At the same time, the makeup of inflation components suggests that elevated inflation readings are here to stay, even if they ease back somewhat from their current levels early next year.
We see this modest repricing of central bank expectations filtering into markets in a couple of ways.
While we have not seen dramatic spread-widening, we are observing an increase in credit spread volatility in both high yield and investment grade markets, and we believe a portion of that is related to these macroeconomic developments.
In addition, we are seeing a more significant strengthening of the dollar, particularly against emerging markets currencies, and again we believe this is partly driven by relative central bank hiking expectations. With the euro already at year-to-date lows against the dollar, and more significant weakness in higher-beta emerging currencies, this repricing makes riskier fixed income assets more vulnerable.
In addition to central bank policy expectations, a second key trend that will likely drive increasing volatility relates to China.
While we think market participants appreciate that China is on a long-term path to rebalance its growth drivers and rely less on property appreciation to drive household wealth, this transition is likely to have its ups and downs.
So far this year, weakness in Chinese fixed income markets has been contained to issuers in the property sector, but we expect more volatility around this process next year. Policy in China is currently getting easier, and we expect further easing into the first quarter of 2022, which should support both growth outcomes and Chinese investment markets—but we also anticipate further direct and secondary impacts from Chinese growth rebalancing on a range of fixed income markets well into 2022.
By contrast, we see much less reason for concern when it comes to general credit fundamentals and issuance trends.
It’s no secret that valuations for credit, securitized and many emerging markets assets are full—spreads are still at close to all-time tights, with bonds exposed to cyclical risks having done particularly well. That said, in our view fundamentals support full valuations in these markets. Largely because of the growth and earnings environment, we expect default risk to remain minimal, with more upgrades than downgrades in high yield markets and minimal corporate activity that would be considered detrimental for bond holders.
Moreover, November has seen an acceleration in issuance, and we think we could see a net decline in corporate supply in 2022, which would be a positive for spread markets. That suggests to us that any pressure in credit markets will likely come more from macroeconomic developments than pure fundamentals.
As we’ve discussed, we continue to think investors should focus on a few key ideas as we enter year-end.
It’s appropriate to reduce risk levels and build cash if, like us, you believe that the drivers of volatility and modest widening we’ve seen in November are a hint at what’s to come in 2022.
We believe it would also be appropriate to move up in quality, move away from cyclicals into financials and more defensive holdings, and focus on short duration and floating rate assets, which should hold value better in a rising rate environment.
In our view, November could turn out to be a glimpse at what’s to come over the next 12 months.