The outlook for bonds in 2023


022 has been tumultuous for both bonds and gilts.

The year has seen a reset of bond yields from uninvestably low to attractively high in all major economies, while the UK and eurozone gilt markets have been thrown into chaos.

But what about predictions for 2023? As recent years have demonstrated, forecasting is not an exact science.

Volatility is likely to persist across most asset classes, given the challenges the global economy continues to face, including inflation, recession, war and China’s Covid-19 policy, to name a few.

However, there are several key trends we can expect to shape the economic outlook next year – and attractive pockets of value that have emerged in Q4.

Rising inflation has been a consistent issue in 2022 and will remain high on the list of headwinds for 2023. Spotlight inflation, driven by energy prices and supply chain issues, has likely peaked and will come down over the next year.

We can therefore expect the interest rate hike cycle, which was at its fastest in 2022, to also slow down.

It is probable that interest rates will peak in 2023 and flatten over the next 12 to 18 months, or even settle at long-term targets.

The allure of corporate bonds

With interest rates stabilising, corporate bonds present an increasingly attractive asset class; high-quality corporate bonds are offering yields of 7 per cent to 8 per cent. However, despite these eye-catching returns, it is important that investors stay selective.

First, the flat yield curve means investors are not being compensated for taking longer-term risks, and so short-to-medium-term duration will remain in focus.

Second, higher-quality credits – especially in the BB/BB+ segment – have sold off more than some riskier names and present a better risk vs reward value.

Moreover, increasing default risks demonstrate why investors would do well to conduct thorough evaluations of companies.

We have been living in the zero-rate environment for many years and are accustomed to discounting refinancing risks. However, inflation and supply chain issues will stress test companies’ business plans, some of which will be unable to withstand the pressure.

In-depth analysis is therefore essential in this economic climate. Investors must ensure companies can handle their leverage given rising interest costs and are resilient to the double-whammy effect of higher costs resulting from inflation and lower revenues resulting from recession.

Most economists agree that recession is a foregone conclusion for the US, UK and other European economies.

Yet in the same way the causes of recession are different in each of these countries, its consequences will also differ.

The US is likely to shrug off recession the fastest and with the least impact, due to fundamental economic strengths, including its labour market.

The outlook for Europe, on the other hand, is gloomier. European economies have struggled to grow even with a decade of zero interest rates aimed at stimulating economic upswing, which alludes to deeper inherent issues.

So what does this tell us about government bonds? Overall, the gilts for these economies call for a higher risk premium.

The impact of the recent meltdown in British politics on UK gilts clearly showed how susceptible the markets are to macroeconomic factors.

Ex-chancellor Kwasi Kwarteng’s tax cuts and spending plans caused government bonds to plunge, and even now, more than two months later, Bank of England governor Andrew Bailey maintains the market is still suffering from shocks.

Given the BoE rate is already at 3 per cent, inflation is continuing to rise and global recession is on the horizon, a half-point yield on a 10-year horizon for gilts should not be sufficient incentive for investors.

Gilts are likely to remain overvalued in 2023, and investors should be wary of buying.

A green transition is needed

These mature economies clearly require a new catalyst for growth – in a best-case scenario, the energy transition and related infrastructure overhaul will provide the necessary impetus for this.

A full-scale green transition would create new jobs, open up new markets and create a new growth sector within Europe.

The implementation and timing of such a transition lies in the hands of policymakers and its relative success will have key repercussions for European economies and the attractiveness of their gilts.

As things stand, the probable recession in developed markets will directly affect emerging markets, which are very dependent on consumption from the former.

The impact on emerging markets has been largely overlooked in recent economic discussion, due to the near unwavering focus on rising energy costs in Europe.

These issues will likely come to the fore in 2023. There is a looming food crisis that has gone under the radar, and the associated inflation will severely impact these economies.

The emerging markets premium therefore requires a similar rethink, considering the macro issues, default risks and global food shock.

In short, investors must not underestimate the impact of macroeconomics on both emerging markets and developed countries’ gilts.

However, allocation to corporate bonds is likely to continue increasing for most institutions over the course of next year.

Fundamentally, bonds are attractively priced and some bonds are even oversold – now is a good time to get back into the asset class and stay invested in 2023.

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