How do the Federal Reserve’s forecasts for the US economy compare with its – modest – projections for the fed funds rate? Should investors target European corporate bonds over US credit? What are our views on emerging markets, particularly on local currency Chinese debt?
Considering the Fed’s forecasts for US inflation – as well as growth and employment – we believe its projections for policy rates do not align with those forecasts. It is peculiar that rates should still be below the 2.5% neutral rate estimate by late 2024, with unemployment at just 3.5% and core inflation still above the 2% target.
So, we expect the Fed to continue to raise its rate guidance as it seeks to return inflation to target. The first rate rise could come this March, with moves to follow at every policy meeting, taking rates to 2.5% or higher by the end of 2023. By comparison, current market pricing suggests policy rates will peak at around 1.8% in late 2024.
In the eurozone, we believe the peak in inflation is near. We expect wages to pick up further in 2022, but probably not by enough to generate an increase in real disposable income.
High inflation numbers have led to more hawkish communications from the ECB in which it has given itself the option to raise rates as soon as in 2023. We actually expect the ECB to not increase rates before 2024.
While US policy rates (and real yields) can be expected to rise in 2022, we do not see this as a meaningful risk to economic growth, company profits or corporate bonds. Although 2022 consensus earnings growth estimates are dramatically lower than last year’s, earnings should more than cover interest payments.
We expect eurozone corporate bonds to outperform US ones given the diverging monetary policies. We favour high-yield. Among the sectors, we are most positive on European banking given the improving economic outlook and the possibility of higher rates.
We believe rising US yields favour being short duration in hard currency emerging market debt.
Asian high-yield bonds have attractive valuations and scope for significant spread narrowing. Investors should recognise Asia credit as a large and diverse asset class beyond Chinese real estate developers. We expect a substantial rally.
More generally on EM, we see attractive opportunities in local currency bonds when EM currencies and rates start to rally.