With very tight labour markets, the concern is core inflation may become entrenched at the same time as growth continues to be challenged. Central banks have now taken policy into restrictive territory to try and slow growth and contain inflation. History suggests this is a very tricky balancing act but given the strength of the starting point for the consumer and corporates, a recession is not our immediate base case in most major markets.
Outlook and Challenges
With terminal policy rates now in sight and policy itself restrictive, the upwards pressure on government bonds should begin to subside but we still would not expect policy cuts in 2023. Cross-market opportunities will likely continue as investors price in differentiated economic outcomes alongside the timing of policy changes.
There are ongoing concerns that the scale of policy tightening already undertaken is putting strain on the banking and real estate sectors with confidence in that space beginning to waiver with a few high -profile casualties. This has implications for broader markets and is a theme which will need close monitoring going forwards.
The next phase of the cycle is likely to involve less growth and lower margins. With that in mind, we have an increase in quality bias and a preference for more defensive sectors. We look for a meaningful deceleration in the momentum of US core inflation as we head into the second half of the year even as the ‘year over year’ numbers remain elevated. Persistently elevated developed market inflation represents a key downside risk to our outlook.
Opportunities and Fund Strategy
This outlook is largely supportive for global fixed income as an asset class. More specifically, we look for outperformance from select local emerging markets as well as U.S. agency mortgage-backed securities (MBS). To a lesser extent, we see opportunities in European credit. In the Emerging Markets space, early and aggressive monetary policy tightening has left several major markets in a position to contemplate easier policy in the second half of the year. This stands in notable contrast to most developed markets where inflation remains problematically sticky.
As global monetary policy becomes increasingly differentiated, we expect cross-market duration positioning to be a source of material alpha. In the agency MBS space, an ongoing dearth of supply combined with a gradual moderation in realized rates volatility provides a supportive technical and fundamental backdrop.
In the corporate credit markets, we continue to favour select European assets over their U.S. counterpart as the former offers significantly more value. Consistent with these views, the Fund is overweight mortgages, overweight local emerging markets, and overweight European credit. On a forward-looking basis, fund positioning will be driven by the ongoing evolution of the economic outlook and market pricing.