Insights and Market Perspectives

Author: David Stonehouse

March 9, 2023

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Less than three months into the new year, the prevailing narrative has changed substantially for the economy. In the fourth quarter of 2022, the consensus view was that peak inflation was behind us and that the economy was decelerating at an alarming rate, both in North America and globally. In fact, by some measures, expectations for an imminent recession were at record levels going back through decades of history. However, history has also shown how difficult it is to forecast a recession. Indeed, whether they be central bankers, economists or investors, observers have struggled to identify recessionary conditions in real time even when they’re in the midst of one.

The first aspect of the consensus outlook – disinflation – has directionally been playing out as expected. Various measures of price changes, including producer inflation, consumer price indexes and personal consumption expenditures, have been decelerating in most Organization for Economic Co-Operation and Development [OECD] countries from their 2022 peaks, although the pace of moderation has been frustratingly slow based on the surprising strength of the most recent data. The trend has also been evident in commodity prices, headlined by energy and food, and core goods prices, which have benefited from an improvement in supply chains and a shift in demand from goods to services. Even some of the more stubborn core service prices have begun to recede from peak levels. This trend, along with concerns about an economic slowdown, drove a bond market rally to start the year as yields declined from last fall’s high-water marks.

Yet recession fears have proven to be misguided. Several factors have contributed to economic resilience. Businesses and consumers have enjoyed an energy dividend in the form of substantially lower prices, as oil and gasoline have fallen some 40% from early 2022 levels, while natural gas in North America and Europe is down in the range of 80%. Capital spending picked up as companies adapted to supply chain issues and strove to replenish sources of raw and intermediate goods in the face of rising geopolitical uncertainty. Finally, consumers still have a stockpile of excess savings from the pandemic response, which in the U.S. could last until at least the summer. As a result, economic data have surprised to the upside. This Goldilocks environment of disinflation and economic growth has changed the narrative to that of a soft landing, or possibly even no landing. In a reflection of the improving outlook, bond yields rebounded in February.

Nevertheless, market participants may once again be latching on to the wrong perspective. First, while the disinflation story may continue for some months to come, we may not be out of the woods yet. In our view, the potential for inflation to reaccelerate later this year may be underappreciated. Here are six reasons why:

1. The tailwind of declining energy prices may be subsiding as supply becomes more constrained, with prices approaching production cost bases and potential geopolitical issues in areas such as Russia/Ukraine and Iran/the Middle East remaining elevated.
2. China’s economy is reaccelerating as it reopens this year.
3. A combination of mid- to upper-single digit cost-of-living adjustments and multi-year contract negotiations at mid-single digit percentages (or higher) levels may keep pressure on wages and services inflation.
4. The economic resilience discussed above, coupled with financial conditions that are actually looser than when the hiking cycle started, is unlikely to allow inflation pressures to moderate as much as officials are hoping.
5. The substantial weakening in the U.S. dollar, which remains close to 10% below its September peak in broad index terms even after a February rally, may generate higher import inflation down the road.
6. Finally, the easy year-over-year inflation comparisons we are currently experiencing become tougher in the second half of 2023, as the economy laps the more benign monthly inflation prints in the latter part of 2022.

For those reasons, we believe the market has been too sanguine about disinflation, as reflected in inflation breakeven levels, which declined through most of 2022 even as investor worries about inflation were top-of-mind. Breakevens have finally started to move higher in recent weeks as markets begin to reassess medium-term inflation prospects – a key factor in the recent rise in bond yields.

The other area the market may not be fully appreciating is the economic outlook. The fabled “pivot” has ended up not being in central bank policy, but rather in recession fears, which have faded from the highest levels ever through “soft landing” to “no landing” in a remarkably quick two months. The outcome, though, is that central bank terminal policy rates have shifted higher and later, another reason for the recent backup in bond yields. Ironically, this reset of overnight rate expectations is resulting in tighter monetary policy. While rate hikes have not derailed the economy so far, the second half trajectory is looking increasingly fragile as the lagged impact of the largest and fastest hiking cycle in a generation takes effect. Add to that a deceleration in capital expenditures from elevated 2022 levels, along with consumers using up the remainder of their excess pandemic savings, and the prospects of recession merely look to have been deferred, not eliminated. Far from “no landing,” we believe the probability of a recession next winter continues to rise.

What does this mean for bond yields?

A potential resurgence in inflation (albeit not nearly as high or intense as in 2022) and near-term economic resilience portend a risk that bond yields may not yet have peaked. However, if a recession does transpire toward the end of 2023 or early in 2024, yields may start to fall later this year in expectation of this outcome. Overall, we expect bond yields to be rangebound in 2023 after the substantial backup in 2022.

For the moment, we continue to hold short-duration positions, although the recent rise in yields is presenting an opportunity to start nibbling again, and we anticipate taking advantage of higher yields to lengthen duration as the year progresses. In addition, inflation-linked bonds are looking more appealing, and we have begun adding exposure again. Our third area of focus has been on corporate bonds with attractive yields. These opportunities include investment-grade bonds with yields well north of 5%, high-yield bonds with yields of 8-10% or more and solid business prospects in our view, and idiosyncratic opportunities in other parts of the fixed income market such as convertible debentures, leveraged loans and Emerging Market debt. In combination, these securities can result in portfolios with mid- to upper-single digit yields.

Since yields should comprise the majority of returns for bond investors (as has historically been the case over time), fixed income returns should not only be much better in 2023 than in 2022, but should also offer a more viable alternative to equities than has been the case through most of the post-Great Financial Crisis period. Bonds now provide a more competitive yield, better potential for downside protection in the event of a recession, and lower volatility than equities despite last year’s elevated risk.

The views expressed in this blog are those of the authors and do not necessarily represent the opinions of AGF, its subsidiaries or any of its affiliated companies, funds, or investment strategies.

Commentary and data sourced Bloomberg, Reuters and company reports unless otherwise noted. The commentaries contained herein are provided as a general source of information based on information available as of March 1, 2023 and are not intended to be comprehensive investment advice applicable to the circumstances of the individual. Every effort has been made to ensure accuracy in these commentaries at the time of publication, however, accuracy cannot be guaranteed. Market conditions may change and AGF Investments accepts no responsibility for individual investment decisions arising from the use or reliance on the information contained here.

This document may contain forward-looking information that reflects our current expectations or forecasts of future events. Forward-looking information is inherently subject to, among other things, risks, uncertainties, and assumptions that could cause actual results to differ materially from those expressed herein.

AGF Investments is a group of wholly owned subsidiaries of AGF Management Limited, a Canadian reporting issuer. The subsidiaries included in AGF Investments are AGF Investments Inc. (AGFI), AGF Investments America Inc. (AGFA), AGF Investments LLC (AGFUS) and AGF International Advisors Company Limited (AGFIA). AGFA and AGFUS are registered advisors in the U.S. AGFI is registered as a portfolio manager across Canadian securities commissions. AGFIA is regulated by the Central Bank of Ireland and registered with the Australian Securities & Investments Commission. The subsidiaries that form AGF Investments manage a variety of mandates comprised of equity, fixed income and balanced assets.

® ™ The “AGF” logo and all associated trademarks are registered trademarks or trademarks of AGF Management Limited and used under licence.

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