Bonds

The ongoing global regime shift toward higher interest rates and less liquidity will drive significant transformations of business investment and the allocation of resources.

Given structural inflation pressures, we expect central banks will be less able to intervene than they historically were when exercising monetary policy to extend expansions and shorten recessions.

Disruptions and dislocations associated with more volatile business cycles have already created opportunities for active fixed income management, as the dramatic interest rate increase of 2022 illustrates. We expect to welcome more opportunities as the regime shift further takes hold.

The business cycle
A business cycle is the overall state of the economy as it progresses through four stages: expansion, peak, contraction and trough.

Factors such as gross domestic product (GDP), interest rates, employment and consumer spending characterize each stage of the cycle.

The expansion phase features economic growth, increased consumer spending, rising employment levels and higher inflation. Declining economic activity, decreased consumer spending, rising unemployment levels and lower inflation define a contraction phase, also known as a recession.

Central banks use monetary policy to impact the business cycle by controlling the supply of money and credit in the economy. Central banks can influence economic activity and help maintain stability by adjusting interest rates and deploying other monetary tools such as increasing their balance sheet (quantitative easing or QE) or reducing it (quantitative tightening or QT).

During an expansionary phase, a central bank may raise interest rates — as many did during 2022 — to decelerate economic activity and prevent inflation from rising too rapidly or becoming embedded in the economy.

Higher rates make borrowing more expensive, which can discourage consumers and businesses from spending and investing.

During times of slowing growth such as after the Global Financial Crisis (GFC) or during the abrupt COVID-19 contraction of 2020, a central bank may lower interest rates to encourage borrowing and spending to help boost economic activity and generally increase inflation.

What matters to policymakers: cyclical or structural inflation?
Cyclical inflation stems from fluctuations in the business cycle and is tied to the vicissitudes of the economy. It is typically temporary and monetary policy tools, such as the adjustment of interest rates, can reverse it.

In contrast, structural inflation refers to inflation caused by long-term factors that are built into an economy, such as supply and demand imbalances, deglobalization, demographics and decarbonization.

Structural inflation is persistent and difficult to counteract and requires fundamental changes in the economy to address it. We have begun to experience such challenges in 2022 after the height of the COVID-19 pandemic when supply chains ruptured and companies reconstructed them, often bringing them closer to home.

In the coming years, we expect labor and energy costs to drive structural inflation higher.

Labor’s share of national income (the amount of GDP paid out in wages, salaries and benefits) has been declining in developed and, to a lesser extent, emerging economies since the 1980s. In the near-term future, we expect higher returns to labor versus capital and for the trend we have seen since the 1980s to end. Why?

  1. Demographics. Aging populations and descending birth rates have resulted in declines in labor force participation rates and tighter labor markets.
  2. Policies aimed at reducing supply chain risks, income inequality and funding benefits for an aging workforce that has not saved enough may require increases in debt-funded government spending.

As a basic economic input, energy costs are intrinsic to all goods and services. We expect energy to be another source of structural inflation for several reasons, including:

  1. Supply and demand. As developing economies grow, the demand for energy will continue to gain. Simultaneously energy-hungry economies are depleting many of the world’s largest carbon-intensive energy reserves.
  2. The transition to decarbonization. Governments around the world are implementing policies aimed at reducing the use of carbon-intensive energy sources while increasing the use of renewables. Until sustainable energy reaches economies of scale, these regulations will likely result in higher energy costs.

Shorter boom and bust cycles ahead
Central bank inflation targeting emerged and spread around the globe in the 1990s and 2000s. Although it was somewhat arbitrary, many large developed market central banks, including the Federal Reserve in the U.S., decided that annual inflation of two percent was consistent with price stability.

Until recently, inflation over the last two decades, as measured by the consumer price index, was generally stable and low, lingering around or below two percent, particularly since the GFC through the start of the pandemic in 2020.

This allowed central banks substantial flexibility to lower rates and even undertake nontraditional monetary policies such as QE when economic growth slowed.

Cheap money resulted in a debt-fueled extension of business cycle expansions and shorter contractions. Central bank intervention is not a recent phenomenon; since the creation of the Fed at the end of 1913, monetary policy has historically extended expansions and abbreviated contractions.

It is interesting to note that the average post-Fed expansion lasted almost twice as long as during the period before the Fed was created while the average post-Fed recession shortened by nearly half as compared to the pre-Fed average. The recent expansion that ended with the onset of COVID-19 set a record of 128 months, almost two years longer than prior expansions.

 
‘Transitory’ to ‘sticky’ inflation
The inflation narrative during 2021 was “transitory,” meaning high inflation was temporary and would not persist.

However, last year when inflation spiked and remained higher than expected, the key term to describe inflation became “sticky.”

While inflation seems to have crested after central banks sharply increased rates in 2022, our views on labor and energy driving structural inflationary pressures suggest that inflation over the longer term will be sticky above the Fed’s target.

This volte-face of the loose money era following the GFC could result in rates remaining relatively high to keep inflation from reigniting, limiting central banks’ ability to meaningfully cut rates or loosen monetary policy to shorten a recession or extend an expansion.

With the expectation of higher structural inflation and limited central bank support resulting in shorter and more volatile business cycles, we believe successfully harnessing credit investment opportunities will require a manager with a proven ability to capture episodic opportunities in oversold areas of the market.

As central banks continue to withdraw liquidity with higher rates and QT, portfolio size is becoming an important consideration as it is increasingly costly to buy or sell cash securities and particularly to reposition larger portfolios. Higher transaction costs for larger portfolios could reduce returns to investors.

We believe the best way to source alpha during a regime shift is by proactively increasing and decreasing credit and interest-rate risk as market conditions change, quickly rotating sector exposure, selectively increasing risk to specific issuers and choosing cheap points of investment within capital structures.

While we expect business cycles to be shorter and more unpredictable in the future, there will always remain opportunities for investors to identify opportunities — even niche ones — in the fixed income market.

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