Back in 2022, bond values plunged as inflation and interest rates jumped. Fast forward two years later, and the position for bond investors has changed dramatically. If we cast our minds back further to 2008, the world was in a precarious situation as the Global Financial Crisis hit markets. Central bankers adopted quantitative easing (QE) to avoid global recession; the US Federal Reserve bought up vast amounts of debt, pumping liquidity into financial markets, cutting interest rates close to zero. Many other central banks adopted similar measures. QE measures were predominately successful, and a prologued global recession was avoided.
However, the prices of risk assets such as equities rose. For investors, there was little incentive to buy government bonds as the payoff for taking on duration risk was negligible. At the same time, many institutional investors such as superannuation funds increased allocations to more illiquid investments such as private assets and other alternative strategies to maintain a defensive positioning given now that bonds were out of favour.
While central bankers were patting themselves on the back for avoiding global recession following the global financial crisis (GFC), a culmination of unforeseen events rapidly changed market dynamics in the years following the GFC. The Covid pandemic and Russia’s invasion of Ukraine contributed to rapidly rising inflation in 2022. A reset in monetary policy was quickly needed, bringing about a rapid rise in interest rates and bond yields.
Rapid interest rate hikes had an adverse impact on asset values, including infrastructure, property and most notably bonds, which had one of their worst years ever in 2022. Furthermore, bonds no longer offered any protection from market volatility as the correlation between bonds and equities turned positive.
Since then, the market environment for bonds has improved. While 2022 was a disaster for bond investors as official interest rates rose and bond prices dropped, returns improved significantly in 2023 as inflation settled down and the pace of official interest rate rises slowed. The outlook for bonds remains positive for 2024 for three key reasons.
1. Inflation has likely peaked
In Australia, inflation peaked in December 2022 at 7.8 per cent; by the end of September 2023, the CPI was 5.4 per cent. Likewise, in the US inflation peaked at 9.6 per cent in June 2022 and by the end of November it fell to 3.1 per cent. We’re arguably close to the end of the interest rate tightening cycle in Australia and other developed nations.
Should central banks begin easing interest rates this year if inflation comes under control, this would be very positive for government bonds and fixed income strategies benchmarked against the Bloomberg Global Aggregate Bond Index. Our base case is that we are likely to experience a global cyclical recession in 2024 though the market is pricing in a ‘soft landing’ scenario. However, if global recession results, which we think is likely, central banks are likely to cut rates aggressively in 2024 and bonds could gain well.
2. Bond Yields
Higher bond yields offer a more compelling investment case for holding bonds as the return on the investment rises. Since their run up in 2022, bond yields have remained elevated partly due to the demand/supply dynamics impacting government bonds, notably US Treasury issuance has increased to fund the US deficit and demand has fallen as demand has deceased following the end of QE programs.
Our expectation for 2024 is for bond demand to rise, driven by households and other investors keen to take advantage of higher yields and the potential for capital gains if central banks cut interest rates. We therefore expect to see bond yields fall from current levels. Until central banks cut rates, however, bond yields may remain elevated despite inflation moderating, as this demand/supply imbalance will take some time to correct.
Bonds have traditionally been a source of diversification within a portfolio, but as noted above, bonds did not provide portfolio diversification in 2022 as bonds and equity prices were correlated. We are, however, entering a more ‘normal’ interest rate cycle. As a result, we would expect bonds to play an important diversification role in investors’ portfolios as they have done traditionally.
While there may still be a few bumps in the road, moderating inflation and a potential loosening in monetary policy should be positive for fixed income investors, reasserting bonds as an important pillar in a diversified portfolio. The turbulence in bond markets seen in recent years has likely gone to bed, paving the way for a much better performance from this asset class.
Lukasz de Pourbaix, global cross asset specialist, Fidelity International