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Uncertainty over inflation and central bank policy is likely to remain high during the first half of 2023 with a wide distribution of potential outcomes. Despite this, analysis shows that bonds already price in most of the downside risk and are expected to deliver favourable outcomes across a number of scenarios, as highlighted in the chart below.

Scenario analysis – A return to form for the role of fixed income

After spending over a decade trying to generate inflation, central banks are today confronted with the highest increases in prices since the 1970s. The return of inflation brings with it an unwelcome dilemma; combat inflation or prioritise financial stability. At the core of this dilemma is whether inflation is structural or cyclical. Whichever it is, and how central banks react, will be key to financial market returns in 2023 and beyond. At the time of writing, it is unclear which combination of outcomes is most likely and good arguments can be made for each scenario.

In the first section of this paper, we set out the arguments for the two types of inflation and provide an overview of the potential reaction functions of both the US Federal Reserve (Fed) and European Central Bank (ECB). The extent to which the Fed will lean toward price or financial stability as well as where inflation lies and how these variables will impact investment returns is then explored through scenario analysis in the second section. The scenarios tested include a soft landing in which inflation moderates, an inflationary bust leading to a hard recession and a milder recession in which the Fed responds with aggressive easing.

Significantly, the results also show core fixed income providing diversification benefits in “risk-off” environments. Out of the five more probable scenarios we have looked at, we only envisage negative returns across all major fixed income sectors for one, that of an inflationary bust. This could occur if inflation remains structurally high for longer and the Fed is forced to continue tightening policy aggressively.

Our conclusion based on this analysis is that fixed income valuations now look potentially attractive. High yield and investment grade credit spreads have not fully priced in the risk of recession, however, the high level of yields now available provide a good cushion to mitigate against the expected widening that would occur under a recession scenario. An increased allocation to bonds therefore may help investors to build more resilient portfolios. 

 

Risk factors you should consider before investing:

• This material is not intended to provide investment advice or be considered a personal recommendation.
• The value of investments and income from them can go down as well as up and you may lose some or all of your initial investment.
• Past results are not a guide to future results.
• If the currency in which you invest strengthens against the currency in which the underlying investments of the fund are made, the value of your investment will decrease. Currency hedging seeks to limit this, but there is no guarantee that hedging will be totally successful.
• Risks may be associated with investing in fixed income, emerging markets and/or high-yield securities; emerging markets are volatile and may suffer from liquidity problems.