The hits keep coming
Stubborn inflation and hawkish Fed pivot add to bond market challenges.
A year ago, we wrote that historically low interest rates combined with rising inflation would make for a challenging year. Unfortunately, we were correct. For only the fifth time in 30 years, the Bloomberg US Aggregate Bond Index posted a negative annual return. The good news: many of our multi-sector strategies had better returns than their respective benchmarks for a fifth straight year. Moreover, the Agg Index never has had two consecutive negative years. Yet 2022 promises to be equally if not more challenging, with Fed tightening and midterm elections on the agenda, joining two elephants already in the room—inflation at its highest level in decades and a Covid pandemic that refuses to go away.
Against this backdrop, and amid an economy that remains constructive for corporate profits and consumers, we are sticking with the strategies that worked for us over the past 12 months. We begin the new year favoring lower-quality, shorter-duration credits (notably high yield and BBB corporates and emerging markets) that are less sensitive to rising rates and more aligned with economic activity. We like bank loans and trade finance for similar reasons, think there’s some value left in Treasury Inflation-Protected Securities and expect rate positioning strategies to again be a significant source of alpha … with a twist. We are short duration on expectations Treasury yields will rise but tactical on the yield curve. We currently favor a flattener as the short end and belly appear likely to cheapen faster than the long end as the market reacts to an accelerating Federal Reserve (Fed).
Moderating economic growth, evaporating Covid stimulus and a shrinking Build Back Better plan (if it passes at all) should restrain increases in yields. How much is debatable. Any moderation in issuance could be countered somewhat by the Fed, which is looking to wrap up quantitative easing by March, the first of three pendulum swings for policy. Regarding the second Fed tool—rate hikes—the debate a few months ago over whether the central bank would hike rates this year at all has morphed into whether four increases are possible before year-end. Minutes from December’s meeting hinted the first policy rate increase could come in March, providing plenty of time for four in 2022. The minutes suggested that the third tool—balance-sheet reduction—could begin this year, as well.
Is the labor shortage structural?
It all comes down to whether inflation will begin to pull back from levels last seen when the late Fed Chair Paul Volcker took it on four decades ago—and won. Amid a rapidly healing labor market and stubborn price pressures, Chair Powell and fellow policymakers tilted their rhetoric to the hawkish side last fall. The rotation of four regional Fed presidents who have argued for pulling back accommodation into voting seats this year should only amplify the shift. We have been vocal all along that inflation was not transitory—at least in the short term—and the Fed now agrees, with Powell in October banishing the word from the discussion. But the question isn’t so much is inflation transitory? Inflation will undoubtedly come down from elevated numbers. But rather, to what level? One of the primary drivers of inflation, wages, keeps exerting upward pressure.
Short of recession, which isn’t on the consensus radar for 2022, it’s hard to see labor shortages that are behind the run-up in wages ending anytime soon. Three forces stick out:
- The Labor Department’s quits rate (the percentage of workers who voluntarily leave their jobs) keeps setting record highs, suggesting the so-called “Great Resignation” is more than a passing fad. Aging boomers are retiring, two-income households are becoming one-income, and many are reassessing their work-life balance.
- Immigration, long a critical source of labor, has come under intense political and social pressure that cuts across both parties. It’s estimated more than 1 million immigrant workers who would otherwise be here are not, in some cases because of the pandemic but also because of steep cuts to legal immigration.
- Even though Covid flare-ups like omicron don’t appear to be as deadly, they keep reinforcing caution among would-be workers and are creating shortages in key industries such as airlines, bus and truck drivers, and schools.
While the last force undoubtedly will ebb and flow, the first two seem like secular shifts that could keep wage pressures elevated even as the supply chain eventually normalizes, indicating inflation may well remain higher than it was pre-Covid. If the market comes to believe this, it’s almost certain to reprice, taking rates higher. It will take some time before we know the efficacy of this secular argument. In the meantime, caution is warranted, which is why we’re hovering near neutral across our recommended sector allocations. The volatility associated with any repricing almost certainly won’t be bond friendly. So, welcome to a new year. It promises to be challenging ... again.