Capital Ideas^TM

Despite interest rates being hiked to their highest level since the mid-2000s and a mini crisis in the US banking sector, the US and other developed market economies remain in relatively robust health. A recession has, so far, been avoided.

One explanation why the usual economic cycle has not been followed might be the unique set of circumstances that have played out since the pandemic or, maybe its just a matter of time and monetary policy is working with longer lags this time around. While a soft landing could be achieved, warning signs of a hard landing persist and there is a path, with a meaningful probability that leads to recession.

Inflation remains central to understanding potential outcomes. Over the past year, it has been easing and it is possible to build a reasonable case for inflation falling back to 3%. However, returning inflation to 2% on a sustainable basis may be a much bigger challenge. From a bond investors’ perspective, the most important consideration is that the slowdown in inflation means central banks are likely at, or very close to, the peak in rates.

The question today is not how much the Fed will continue to hike rates but for how long it will keep rates at these levels. This is a supportive environment for fixed income. If central banks do maintain policy rates higher for longer, bond investors will continue to benefit from the high level of carry. If, on the other hand, policy is eased, bonds benefit from both the initial high carry and the positive duration impact of falling rates.

To help investors better understand how to navigate what remains an uncertain macroeconomic backdrop, we undertook sensitivity analysis of the global investment grade corporate bond market. Four outcomes were looked at: Goldilocks, recession, a continuation of the current environment and a reacceleration of inflation.

We find that investment grade credit is well placed to provide positive returns over one year given the most likely macroeconomic scenarios. The only outcome where we see negative returns is under a reacceleration of inflation. Even then, the high level of yields available in the asset class today help to reduce losses, with the negative outcomes less severe than those incurred during 2022.

Our analysis points to one clear implication: the importance of investing in fixed income despite ongoing uncertainty. Given the set of likely outcomes outlined in this paper, we believe fixed income markets have become a much more attractive proposition for investors. Credit markets in particular now offer sufficient carry to offset periods of potential volatility.