A different scenario for fixed income

If we look at market behavior from a growth/inflation perspective, the current combination (slowing growth/rising inflation) is possibly the most complicated for risk assets. This complication is being passed on to central banks, which face the problem of fighting inflation in an environment where the rate of change in growth is clearly turning downwards.

As we say, this scenario is difficult for all risk assets, but it is especially complicated for fixed income, which is suffering the rigors of a world that has gone from having no inflation to registering it in a way that far exceeds the standards of the last forty years. Logically, this has translated into the worst four-month period for bonds since 1992, leaving losses that are even higher than those of a more volatile asset such as equities.

With inflation rates approaching double digits in some geographical areas and with central banks that have made a 180-degree turn in their monetary policy, it is not surprising that the sentiment on assets is one of absolute pessimism and that the outlook for the coming months is really gloomy. We are at a time when the market is discounting almost ten rate hikes in the United States and in Europe positive intervention rates are already anticipated at the end of the year and, of course, the end of bond purchases by the ECB. In other words, the market is already pricing in the worst-case scenario with negative sentiment on fixed income at its highest levels in decades.

From a management point of view, it is always interesting to propose alternative scenarios to those discounted by the majority of the market. Over the past year, the predominant narrative was to dismiss inflation as a working hypothesis, due to its supposed transitory nature. Now, however, the argument for the current situation is based on runaway rising inflation in the coming months and central banks determined to do whatever it takes to contain it. Neither of the latter two assumptions has to be fully true.

First of all, it is indisputable that the inflation levels currently reached are alarming, but it is also true that there are factors that may be draining inflation over the coming months. To begin with, energy prices would have to continue to rise at an unacceptably high rate, given the existing demand, in order to maintain the current rate of inflation. On the other hand, in the United States, the savings rate has already normalized to pre-pandemic levels, so that the pent-up demand that was pent-up savings has already disappeared and wages have not grown sufficiently to cover inflation. If we put the two things together, less money available and higher prices, we find ourselves with a depth charge to consumption which, let us remember, is 70% of US GDP.

The second premise is that of central banks focusing on inflation and forgetting about growth. It is logical that the highest monetary policy bodies want to avoid past mistakes and not act too late on interest rates (as happened in the 1970s), but possibly in the second half of the year we will see them turn their sights (albeit sidelong) to future growth that is far from solid. In this sense, central banks are enjoying the "extra ball" that the market has given them by pricing in such aggressive rate hikes.

A scenario in which the inflation rate gradually moderates and central banks modulate their discourse towards a less restrictive zone would be extremely positive for portfolios with duration. Precisely where almost nobody wants to be today.  

But it is not only duration portfolios that will benefit. Conservative investors are probably the ones who are going to notice the brutal change in fixed-income markets the most. For example, the volume of global debt with negative yields has almost quadrupled in the last year, in a move that represents a normalization of an extraordinary situation, which is that you have to pay to lend your money. This means a fundamental change for this conservative investor who a few months ago had no positive return alternatives of a certain credit quality, and now finds himself with the possibility of investing in short-term portfolios, with investment grade credit quality and yields above one percentage point. As we have done in Finaccess Short-Term Fixed Income to provide a solution for the conservative investor. This is an alternative to the still negative, or at best zero, remuneration of instruments traditionally associated with this type of investor, such as deposits.

Great opportunities come with volatility and extreme swings, and what we have experienced in these first four months is fully identified with these two factors. Thinking about a different scenario for fixed income can be hugely beneficial for both riskier portfolios and for the conservative investor in need of positive returns.

Column by David Ardura, co-chief investment officer at Finaccess Value