What's top of mind for fixed income in 2023?

I'd like to share a few things that are on our mind about fixed income as we head into 2023. First, higher yields are a good thing. They indicate higher future returns. Yields on fixed income pools are three times as high as they were at the end of 2020. Second, about the correlation between fixed income and equities. While bonds failed in delivering their insurance qualities to our portfolios, it was due to high and fast rising interest rates driven by inflation.

As the Fed is nearing the end of its tightening cycle that correlation typically goes back to negative. Third, we believe that the Fed is in a fight of its life and will sacrifice growth in favour of credibility. During the Jackson Hole meeting in August 2022, Jay Powell, in an eight- minute speech, used the word ‘inflation’ 46 times, ‘economy’ eight times and ‘employment’ only once.

By the way, he also said they will keep at it until the job is done, twice. And “Keeping At It” is the title of Volcker's autobiography. Fourth, we note economic weakness ahead is highlighted by reliable indicators. If recession is not avoided, bonds will be a good asset class to hold in 2023. If it were to be avoided, it would likely be on account of significant stimulus from China, which is not a high probability scenario.

Fifth point: when we think about the yield curve, we know that we have been through a “very negative for bonds” bearish flattening scenario in 2022. Typically, it is followed by bullish steepening scenario, which favours duration and investment grade bonds and cautions on high yield. Sixth point is that while quantitative tightening will definitely be a negative for bonds in 2023, there is going to be meaningfully lower issuance of debt next year, and as a result, the supply-demand imbalance is going to improve in favour of bonds by about 1 trillion, according to J.P. Morgan Research.

And finally, about the U.S. dollar. U.S. dollar overshot in strength against purchasing power parity by more than 20% this year. Typically, these overshoots last months, not years, and if U.S.-dollar strength reverses in 2023, that's a scenario that would be very positive for EM assets which suffered this year, both on account of rising interest rates and stronger dollar.

In short, we believe 2023 is not a year to abandon fixed income.

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Original Publication date: December 22, 2022