Omnis Weekly Market Update – 26 September 2022
A positive outlook for bonds
With inflation spiralling and central banks raising interest rates, it’s been a tough year for bond markets. Nicolas Trindade, senior portfolio manager at AXA Investment Management and manager of the Omnis. Short-Dated Bond fund, explains what has been happening this year and why he thinks conditions are going to improve for investors.
It’s been a difficult year for bond investors so far. Inflation has hit a 40-year high in many
countries, driven by ongoing supply chain problems, pandemic stimulus measures and the war in
Ukraine. In response, central banks have started to raise interest rates to try to tame inflation.
Since the US Federal Reserve (Fed) started to hike rates, bond prices have fallen (they move in
the opposite direction to yields). Meanwhile, bonds in many European countries had their worst
month in decades in August, as surging gas prices exacerbated inflation. UK gilt yields have risen
by more than 2% since the beginning of the year.
The good news for investors is that bond yields are likely to fall over the medium term
(meaning prices will rise). That’s because expectations for both inflation and interest rates are
probably too high.
The reason why UK gilts underperformed in August is largely because of the uncertainty
surrounding the government’s fiscal policy (government spending and taxation) due to the
Conservative Party’s leadership contest.
Bond yields went up after markets were spooked by Liz Truss’s talk about tax cuts and increased
spending. Investors were concerned that these policies could push inflation higher, prompting
further interest rate hikes in response. With the new government in place, we look forward to
the clarity that forthcoming policy announcements on spending plans should provide.
Meanwhile, the bond market is pricing in a series of interest rate rises by the Bank of England
taking rates up to 4.25% by the middle of next year. Even though it may take some time for
inflation to fall back to the Bank’s 2% target, we believe rates are likely to peak at around 3%.
Yields on UK government bonds should begin to fall as investors reassess the extent to which
interest rates might rise. Therefore, the outlook for UK government bonds over the next 12
months is positive.
It’s likely US Treasury bonds will experience a similar pattern. Markets are expecting US interest
rates to peak at around 4%, although we think the figure will be lower at about 3.5%.
This means markets have probably gone a bit too far again. In the shorter term we should see
some consolidation in yields, which may fall slightly, resulting in Treasury bond prices going up.
US inflation has peaked and should start coming down over the course of 2023 to around 5%.
So expect to see a less aggressive stance from the Fed which, having stopped raising interest
rates around the end of this year, will probably start to cut interest rates towards the end of
2023. With less inflationary pressure from the war in Ukraine, the outlook for US Treasuries is
arguably looking more positive than for UK bonds.
For decades bonds have been the perfect portfolio diversifier, providing protection when
market conditions are challenging. Bonds usually help to diversify a portfolio as they tend
to rise when stock markets are falling. However, this year stocks and bonds have been falling
in tandem at a pace not seen for many years, leaving investors with few places to hide from
market volatility.
Yet we believe they still have a valid role to play in multi-asset portfolios to help mitigate the
unpredictability of stock markets. As economic growth cools and inflation comes back under
control, high-quality bonds will almost inevitably become a good diversifier once again.
Over the past 70 years, there have been nine individual calendar years where equities and
bonds have both fallen (figure 1). However, history shows us that each time this happens, the
markets have always returned to normal, and there’s no reason why they will not do so again
this time.
