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6 Sep 2023 - Compelling case for bonds as recession looms

By: JCB Jamieson Coote Bonds

Compelling case for bonds as recession looms

JCB Jamieson Coote Bonds

August 2023


Central banks the world over have hiked rates with unprecedented velocity and ferociousness as they look to rein in inflation. With this hiking cycle now nearing its peak, Jamieson Coote Bonds senior portfolio manager, James Wilson says investors should assess their portfolios and take advantage of emerging opportunities in fixed income.

KEY TAKEAWAYS

  • The global economy looks set for recessionary conditions, following the historic trend of US Fed hiking cycles creating financial crises somewhere in the world.
  • This current rate cycle is nearing its top, but stickiness in key inflation metrics mean interest rates are unlikely to fall below 2% anytime soon in Australia.
  • This same stickiness is expected to support bond yields, making a compelling case for high-quality government bonds as equity and property markets grapple with significant volatility and global debt burden.

BRACING FOR A SLOWDOWN

Since March 2020, the geopolitical forces shaping markets have shifted dramatically. Markets have lurched from a global pandemic to the outbreak of Europe's first land war since conflict rocked the Balkans in the 1990s.

Meanwhile, rising nationalist sentiment across other major economies has polarised the political landscape - particularly in the US.

Economics and markets: a dose of reality

Source: Jamieson Coote Bonds

More recently, Mr Wilson said investors have contended with a "world of overshoots".

"We've seen oil travel from -US$30 to over US$120, and back to somewhere in the eighties where we are now.
"We've had the Bitcoin bubble. We've gone from US$5,000 to US$68,000 where we all wanted to be part of the big bubble there until it all popped and went back to US$16,000. And that's since recovered again. Now we are seeing equities being led by Artificial Intelligence.
"All this is happening in a highly indebted world where US mortgage-holders are under trillions and trillions of dollars of debt."

 

It's not just mortgage debt that's expected to provide headwinds for markets. Mr Wilson noted that US credit card debt is hovering around the US$1 trillion mark1.

Taken together, Mr Wilson said these indicators suggest the market is "cycling between the late 'upswing phase' and the 'economy slows' phase. In blunter terms, global markets appear to be heading towards recession.

Where are we at in the business/investing cycle?

Source: Jamieson Coote Bonds team analysis

CHARTING A COURSE FORWARD

Looking ahead, Mr Wilson said the uncertainty hanging over markets will likely remain, however clues to what might play out can be found by looking back to 2007, right before the Global Financial Crisis struck.

"As we know, nothing really happened, and then everything happened," he said.
"Rates hit 5%. You could buy a 3-month T-Bill for above 5% for more than a year, and then everything came crashing down."

Precisely what will cause a recession this time around is more difficult to pinpoint, Mr Wilson said - and the lagging effects of monetary policy mean the trigger could still be a while off. When it does hit, however, Mr Wilson said the United Kingdom and Europe will likely feel its effects first.

"They've got big exposure to energy, and they're against the US dollar," he said.
"Then the US and then Australia would go into recession as inflation and jobs will lead unemployment rates to go higher."

Historically, Mr Wilson said, rate hiking cycles undertaken by the US Fed invariably create a financial crisis somewhere in the world.

INFLATION EASING SLOWLY

Inflation has become a hot-button issue for investors, policymakers and a majority of households over the past two years. The US Consumer Price Index (CPI) peaked at 9.1% in June last year, with Australian CPI reaching a peak of 7.8% in December that same year.

Since then, CPI figures have steadily reduced. In the US, inflation is sitting just above 3%, while Australia's July CPI print came in at 6%.

"These are outstanding moves," Mr Wilson said.
"I know central bankers aren't making many friends hiking interest rates as the cost of living pressures that everyone's suffering from globally, but it's been the right idea. It's going to help economies."

Mr Wilson added that the Citi Inflation Surprise index - which measures forecasters' expectations against realised inflation data - showed that since 2020, inflation was consistently higher than expected.

In the past few months, this trend has been broken. "We're no longer seeing surprises to the upside," Mr Wilson said, "which means we're not getting the volatility in the data, which means we most likely aren't going to see binary moves in the actual bond yields."

Although inflation expectations are starting to ease, Mr Wilson said he doesn't expect to see CPI dip below 2% "anytime soon", and that inflation will likely remain 'sticky' for some time.

OPPORTUNITIES EMERGING FOR ACTIVE MANAGERS

Leading into the Jackson Hole symposium, US bond markets are pricing in rate cuts between 120 and 130 basis points for the year ahead.

"That isn't necessarily saying that we (Australia) are going to have 120 basis points of rate cuts. What that could be saying to bond traders is that there could be a 50% chance of close to 250 basis points of cuts," Mr Wilson said.

In Australia, market pricing tells a different story - one more interest rate hike (likely before the end of the year) and no 'big' rate cutting cycle like US markets are expecting.

Interestingly, Australia's three-year bond rate currently sits at 3.8% - 30 basis points below the cash rate. In the US, that gap between the three-year bond rate and the cash rate is closer to 100 basis points.

"If you think about that level, Australian three-year bonds are actually quite cheap in that sense because they're not pricing in any of the rate cutting cycle. There are definitely opportunities to be owning those assets," Mr Wilson said.

Mr Wilson also noted that bond and share market yield curves are "not too dissimilar", suggesting the credit stack is upside down.

Bond yields are genuinely compelling for investors

Where are investors securing their yield from, and at what cost to the portfolio?

Source: JCB team analysis, based on data from Bloomberg

Similarly, property cap rates are starting to 'come into line' with bond yields, Mr Wilson said, making a 'compelling' case for bond investment. This is further evidenced by the state of US deficits, Mr Wilson said, which suggest there's a huge amount of issuance yet to come.

"And at some price point, bonds will clear. There is a price that's going to cheapen up, but bonds will clear at some price and someone will buy the US treasuries and the Australian government bonds for that matter at a level."

The money used to purchase those assets somewhere - whether credit, equities or something else, the money will come from somewhere to fund these purchases, Mr Wilson said.

"We're already seeing that in asset allocations, that makes bonds a very compelling investment option over time, and we expect this to continue."

1. A Saphir, 'US credit card debt tops $1 trillion, overall consumer debt little changed', Reuters, August 9 2023, accessed 15 August 2023


Funds operated by this manager:

CC Jamieson Coote Bonds Active Bond Fund (Class A)CC Jamieson Coote Bonds Dynamic Alpha FundCC Jamieson Coote Bonds Global Bond Fund (Class A - Hedged)

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