Interesting times for fixed income

According to Alex Cousley, CFA — APAC Investment Strategist at Russell Investments — investors are at an interesting juncture with fixed income markets. That’s because Russell Investments believes that many countries around the world have actually over-tightened on monetary policy, with the most notable being the U.S. Federal Reserve.

“In our scenario modelling, we think a recession in the U.S. is more likely than not over the next 12 months,” says Alex. “We don’t think it will be a severe recession, but rather a mild to moderate recession — where GDP drops to 1-2 per cent and the unemployment rate jumps to 5.5-6 per cent.”

He says the yield curve in the U.S. has inverted, which is a good predictor of recession, with Alex believing the U.S. will slip into recession in Q4 this year or the first half of next year. He adds it’s a similar story for the U.K., with Europe also at an elevated risk of recession.

Back at home, Alex says there are signs the Australian economy is slowing quickly, but he doesn’t believe the risk of recession in Australia is as prevalent as other countries. It’s a view supported by Jonathon who is confident that inflation in Australia will moderate, and although growth will slow, he believes this will not slow to the extent it will cause a major recession here.

Jonathon believes there are a number of factors as to why the recession risks in Australia are more moderate compared to the U.S. and other countries.

“We have benefitted from an increase in commodity prices, like iron ore and agriculture. Australia is definitely benefiting from its ongoing net exports, which has improved the bottom line. We also have a significant boost to our immigration numbers, which is supportive of GDP. In addition, the reopening of supply chains, including China, has been positive for the Australian economy.”

However, Alex concedes that Australian households with mortgages are starting to feel the interest rate pain, as they transition from fixed rate loans to variable rate mortgages.

“It’s encouraging that quite a number of households have built up a sizeable stockpile of savings. The RBA estimates that 40 per cent of households have two years of prepayments as a buffer for their mortgage,” says Alex. “And while there is a part of the household sector that is vulnerable to interest rate increases, there is also quite a large number of households that have been preparing for higher interest rates and are well positioned to absorb these rate increases.”

That said, Jonathon’s expectations for inflation over the long-term is that it will move back towards the target band of central banks, which is around 2.5-3 per cent, however, he acknowledges that inflation has been quite sticky and is taking some time to moderate. When it comes to forecasting long-term inflation, Alex says the one thematic Russell Investments continues to grapple with is the extent to which ‘greenflation’ — the clean energy transition — will have on the economy. This, he says, has yet to play out.

With the risk of recession lower in Australia than other countries — like the U.S., U.K. and even New Zealand — Alex believes Australian fixed income looks fairly attractive. He believes duration is presenting an appealing opportunity for investors, particularly in government bonds (with the exception of Japan), which will provide investors with the benefits of diversification, particularly in an environment that may slow down considerably or even dips into recession.

“We also think that valuations look attractive across most regions,” Alex says. “In addition, we’re quite upbeat on private credit. We’re getting high quality exposure though our private credit managers, and some of it is also with floating rates, which has been an attractive opportunity over the last 12 months, given that rates have been moving higher. There is still a lot of demand from our private credit managers for capital, because as money tightens and the banks step back from lending, they are seeing more opportunities in the market.”   

Alex accepts that the move towards deglobalisation, with the likes of the U.S. and its allies (including Australia) seeking to decouple and de-risk from China, will probably lead to slightly higher inflation over the short to medium-term.

“The reality is most developed economies can’t compete with China in terms of labour costs. So, decoupling will likely lead to a lot more investment in automation and robotics to help drive down production costs. That means over the short to medium-term, inflation will likely be a little higher, but over the long-term it will stabilise and track back down.”

He adds that while there are definitely parts of the economy that will decouple from China — citing the COVID pandemic as a good example of not being reliant on other countries for medical supplies — it may be harder to do that with other parts of the economy, like electronics and consumer goods. Alex says the Asian supply chain is extremely tight knit, particularly around consumer goods, which may instead prompt the democratic West to move from China to countries like Vietnam, Indonesia and India to source these goods.

Jonathon agrees, adding there will be greater ‘onshoring’ and ‘friendshoring’ of supply chains. As an example, he refers to Mexico and the U.S., which already have close ties. This will provide greater opportunities for investors to invest in ‘friendshoring’ countries, like Mexico.

Finally, when it comes to geopolitics, Alex doesn’t believe markets are underestimating the potential risks around protracted conflict between Russia and Ukraine. Instead, he says, the focus will increasingly shift to China and Taiwan, which he believes will intensify as we approach the Taiwanese presidential election in January 2024.