2022 Outlook – Fixed Income

As the investing world enters 2022, one of the most visible debates centres on a topic many market participants have given up for dead—inflation. A whole generation of professional investors have come and gone since the risk of higher inflation from loose monetary policy came to fruition. Those on the side of temporary inflation do not dismiss its existence, but favour supply chain disruptions and other transient factors as the drivers. The other more concerned group point to a surge in the money supply in circulation (a shocking 23% above trend) that has facilitated retail sales growth 10% above trend. As with most economic puzzles, the best answers lie between the two extremes.

Source: Bloomberg Finance L.P., as of December 14, 2021. Canada CPI as of October 31, 2021; U.S. CPI as of November 

We expect inflation data to remain stubbornly elevated throughout the first half of 2022 before the worst of the supply chain constraints are alleviated.  The trend in the second half of 2022 is likely to lower inflation prints, though we suspect the equilibrium level will be well above what we were used to pre-pandemic at 2%. This will present opportunities as interest rates and the shape of the yield curve will exhibit continued volatility.

The recent bullish curve flattening seems premature to us as it equates to a terminal overnight interest rate of approximately 1.50% to 1.75%. This suggests the bond market believes the U.S. Federal Reserve is making a policy error in hiking rates in 2022 and 2023, and a recession could soon follow. That is not our forecast. Instead, we’re looking for a corrective bear steepening of the yield curve in the near term. However, investors must stay alert because a yield curve flattening strategy is likely a winning one later in the year. Active management is necessary to navigate these gyrations.

Source: Bloomberg Finance L.P., as of December 14, 2021

The Bank of Canada has been leading central banks in withdrawing emergency levels of stimulus by an early tapering of quantitative easing. However, we disagree with the peak pricing of nearly 175bps of hikes in 2022 that the market has traded to recently. Our funds will continue to add 2-Year Government of Canada bonds on these opportunities as the expectation is for about half of that amount of tightening in 2022. We continue to expect above trend economic growth, elevated inflation for longer and modestly higher overall rates.

Positioning and opportunities

Generally, our fixed-income funds enter 2022 short of benchmark duration and with a bias to higher long-term rates. We are comfortable with a moderate overweight in corporate bonds and would look to add to this position on any meaningful yield spread widening.

The backdrop for businesses is still quite attractive for credit investors. Increasing revenues, stable margins and low interest expenses are a good recipe for cash flow generation. Yield spreads reflect this positive set up, but we believe the previously mentioned volatility will provide some buying opportunities, so we look to be tactical in trading our investment-grade credit book.

In our more aggressive credit funds, we favour the high-yield sector. The financial characteristics cited above, combined with our view of a much healthier universe of high-yield issuers, leads us to this investment preference. The lower rated segment of the market has experienced a positive quality drift (a higher ratio of BB to CCC issuers and secured versus unsecured debt) that supports current valuations.  Our view of the U.S./Canadian dollar exchange rate is it is range bound heading into 2022 and, until the 1.20 to 1.30 range breaks, we will adjust our hedges accordingly.

Risks

The current environment calls for investors to be nimble and humble. This means tactical trading around strategic positioning. It’s possible inflation could deviate from our predicted path in 2022. It’s also possible neither the Bank of Canada nor the U.S. Federal Reserve calibrate their response to inflation in the most optimal fashion. To be fair, they are out of practice in this regard. The risk of further fiscal stimulus stoking a healthy economic fire exists, as does the extended valuations in equities. While defendable with low inflation and quantitative easing, these valuations may suffer a re-rating if rates become more positively correlated to inflation data.

Glossary

Quantitative easing: monetary policy whereby central banks increase money supply in the markets to encourage lending and investment.

Yield spread: the difference between yield (rate of return) on different debt instruments, typically measured in basis points.

IMPORTANT DISCLAIMERS

This document is provided as a general source of information and should not be considered personal, legal, accounting, tax or investment advice, or construed as an endorsement or recommendation of any entity or security discussed. Every effort has been made to ensure that the material contained in this document is accurate at the time of publication. Market conditions may change which may impact the information contained in this document. All charts and illustrations in this document are for illustrative purposes only. They are not intended to predict or project investment results. Individuals should seek the advice of professionals, as appropriate, regarding any particular investment. Investors should consult their professional advisors prior to implementing any changes to their investment strategies.

The opinions expressed in the communication are solely those of the author(s) and are not to be used or construed as investment advice or as an endorsement or recommendation of any entity or security discussed.

CI Global Asset Management is a registered business name of CI Investments Inc.

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Published January 10, 2022