16 December 2021
Saying goodbye to 2021 but not to inflation
With 2021 drawing to a close we examine how inflation impacted the year and our outlook for fixed income markets as we enter 2022.
The fundamentals of fixed income markets have changed considerably over 2021. We have moved from a market environment expecting the Federal Reserve (Fed) to be on hold for years to come, to a Fed having the “optionality” to tighten monetary policy and the market pricing multiple hikes in 2022. Three new Covid-19 variants were designated by the World Health Organisation in 2021 which led to further disruptions to supply chains and international travel. However, it was the ever extending timeframe for “transitory” inflation which was the greatest surprise of 2021. Currently, US inflation has surged to the highest levels seen this century. This has been due to a multitude of factors such as higher shelter and car prices, which are both expected to continue rising as we enter 2022. Services inflation is also picking up whilst core goods inflation has increased by over 9% year-on-year. With this said, economic growth remains strong and corporate health is resilient as companies are able to pass along these inflated costs to consumers. This has helped corporate default rates fall below long-term averages.
US inflation at the highest levels seen this century
The Fed is expected to finish its asset tapering programme in spring next year and from here the market is pricing a hike per quarter for the remainder of 2022. Valuations are tight in investment grade credit with an Option Adjusted Spread (OAS) of 97 basis points (bps) in both the US and Europe. Moving further down the capital structure, high yield OAS appears attractive near its average at 330 bps in the US and wider than average at 341 bps in Europe. In emerging markets, valuations also appear attractive at 152 bps for investment grade and 506 bps for the high yield components of the J.P. Morgan Emerging Markets Bond Index.
With the expected rises in central bank rates, the market currently holds a large short duration bias in rates markets with the standard deviation of these positions at multi-year highs. Over the holiday period supply and liquidity are typically scarce in investment grade and high yield markets, however January is expected to see a large amount of issuance and liquidity returning to fixed income markets.
What does this mean for fixed income investors?
As inflation is high, and expected to continue to be high, a short duration position appears favourable as central banks raise rates over the coming quarters. We expect risk assets such as high yield and Additional Tier 1 (AT1) bonds to benefit from the strength of corporate health, along with attractive valuations and low default rates. Emerging markets present a more unclear binary consideration with a tailwind of cheap valuations contrasting with a tightening of monetary conditions from developed markets.
About the Bond Bulletin
Each week J.P. Morgan Asset Management's Global Fixed Income, Currency and Commodities group reviews key issues for bond investors through the lens of its common Fundamental, Quantitative Valuation and Technical (FQT) research framework.
Our common research language based on Fundamental, Quantitative Valuation and Technical analysis provides a framework for comparing research across fixed income sectors and allows for the global integration of investment ideas.
Fundamental factors include macroeconomic data (such as growth and inflation) as well as corporate health figures (such as default rates, earnings and leverage metrics)
Quantitative valuations is a measure of the extent to which a sector or security is rich or cheap (on both an absolute basis as well as versus history and relative to other sectors)
Technical factors are primarily supply and demand dynamics (issuance and flows), as well as investor positioning and momentum