To start the year, we think it’s appropriate to revisit positioning within bond allocations while recognizing there remains a healthy degree of uncertainty.
Last quarter, we wrote about how investors should approach fixed income as we rounded out a difficult performance year given hawkish central banks and elevated interest rate volatility. To start the year, we think it’s appropriate to revisit positioning within bond allocations while recognizing there remains a healthy degree of uncertainty.
In line with that uncertainty, our friends on our fixed income investment desk recently released their surprise predictions for 2023. “Surprisingly”, some predictions may already be playing out, however, the truth is investors should first consider what incoming data are signaling, what’s in the ‘price’, and, while considering some tail risk surprises, maintain broad diversification across bonds to not be caught off guard in either direction.
Current data suggest three realities: inflation is cooling; job growth remains firm, but is likely to moderate, as will wage growth; and services and manufacturing data point to broader economic slowing. With this backdrop, it appears the Federal Reserve (Fed) remains vigilant in its efforts to bring inflation down faster by way of higher rates, yet markets aren’t buying what the Fed is selling. Markets still anticipate almost two rate cuts in the second half of 2023, while policymakers expect to keep rates on hold at or above 5% through 2023.
On the surface, it appears long term bond yields and credit spreads are pricing in a soft landing. But the reality is bond markets are in a tug-of-war between persistent hawkish rhetoric from the Fed and signs of slowing growth and moderating inflation.
Given this, bond investors should focus on the following:
- Maintain a high-quality bias in portfolios. Slowing economic growth seems most likely, and while the debate between hard or soft landing will continue, credit spreads likely need to widen further as growth slows and defaults rise.
- Maintain a short-duration overweight, while adding duration when yields move higher. Bond yields are likely range bound as the upside risk to the Fed overshooting is limited and should be partially offset by slower growth and inflation.
- Embrace securitized sectors. Asset-backed securities are still supported by a strong consumer while mortgage-backed securities are presenting new opportunities after a challenged 2022 and light supply.
- Diversify across sectors. Although cash was one of the few positive sectors last year, as shown, over time broad diversification has delivered the best risk-adjusted returns for bond investors. Moreover, the valuation reset last year was broad based, presenting attractive opportunities across the bond spectrum in 2023.