As inflation recedes, focus on quality and security selection.
The return of meaningful price inflation was something that many had anticipated in recent years, but the circumstances and intensity of its resurgence caught most investors by surprise in 2022. From ultra-accommodative monetary policy to a post-pandemic demand surge to supply chain disruption to the Ukraine War’s impact on commodities prices, multiple forces drove inflation to 40-year highs. After initially viewing the changes as “transitory,” the U.S. Federal Reserve initiated an about-face. The central bank hiked rates tentatively at first with a 25-basis-point increase, but then accelerated to 75bps per meeting for most of 2022 before slowing to a 50bps hike in December. Meanwhile, after peaking at 9.1% in June, U.S. Consumer Price Index inflation receded to 7.1% in November, while core inflation eased to 6%. Impacts of the Fed hikes and a slowing economy are appearing in pockets of the U.S. economy, notably housing, technology and manufacturing.
In Europe, inflation has been even more acute amid energy shortages, though the European Central Bank has trailed the Fed in its tightening program. Developed markets generally have been moving to curtail liquidity, driving general consensus for a global recession this year—the extent of which is subject to considerable debate.
Looking into 2023, we believe that inflation will almost certainly retreat further from peak levels, although it is likely to remain well above norms throughout the year and into 2024. As expressed in their meetings and policymaker comments, central banks understand the need to maintain tight conditions in order to tame pricing pressures. So, although we could see just a couple more hikes, U.S. short rates are likely to remain high for some time. In other words, the world of zero interest rates that was so prevalent after the Global Financial Crisis is likely over.
What does this mean for markets? First, interest rates will probably trade within a much tighter range than in 2022, as inflation moderates and central banks hike at a more gradual pace. Second (and related to the first point), duration exposure should be less risky than it was in 2022, with the added benefit of far more generous yields providing a cushion against potential negative total return. Finally, fundamental concerns about credit are likely to increase, not just due to macro developments, but as a function of individual issuer dynamics and financial positions. As a result, individual credit exposures could be a key driver of portfolio outcomes, making security selection more important than ever in seeking to achieve investment success.
Below, we address some key themes we anticipate for fixed income in 2023. For a snapshot of our market views, see the table at the end of this page.