The end of easy
The Federal Reserve’s hawkish pivot was unsurprising given the persistence of high inflation. Aside from doubling the pace of tapering, the median Federal Open Market Committee (FOMC) member is now projecting three 25 basis points interest rate increases in 2022 and 2023 respectively. The Fed’s policy announcement merely confirmed what bond markets had anticipated, which largely explains the muted market reaction.
The Fed is not alone in its hawkish turn. Europe’s major central banks have signaled a quicker end to their crisis era policies. The Bank of England surprised markets by lifting its bank rate for the first time in more than three years, while the European Central Bank signaled it would taper quantitative easing steadily throughout 2022. This effectively marks the end of an emergency easing cycle that has underpinned the significant rally in risk assets.
Greater market volatility is par for the course in 2022 as the global economy transitions from containing Covid-19 to living with Covid-19 and continues to reckon with supply and demand imbalances that the pandemic had wrought. Meanwhile, the retreat from ultra-accommodative monetary and fiscal policies may portend wilder price swings and more moderate returns.
Still, these do not necessarily herald a risk-off environment. After all, policymakers are only gradually winding down support because growth is expected to remain robust. Case-in-point, the FOMC upgraded its growth forecast for the US economy in 2022 to 4% from 3.8% previously and projects a brisk decline in the unemployment rate from 4.3% this year to 3.5% in 2022.
Balancing risk and reward in the quest for income
This is to the benefit of income-seeking investors as some prudent risk-taking will be important to earn a reasonable level of income given the combination of historically low nominal yields and high inflation. The latter tends to erode the real value of fixed income streams.
As it stands, real yields of developed market government bonds remain firmly negative and have dragged returns in the broader bond market lower. Consequently, investors will have to expand their search for yield across a broader fixed income universe, both on a sector and regional basis, and accept some credit risk for yields that reasonably outpace inflation.
Here, there are compelling opportunities in emerging markets (EM). For one, EM bond yields have moved up sharply in 2021 resulting in reasonably positive inflation-adjusted yields, as EM central banks had begun raising interest rates in earnest to contain inflation and mitigate depreciation pressure on their currencies.
Meanwhile, with central banks broadly on a tightening path, investors should consider staying short on duration. Due to its floating rate structure, bank loans are an ideal candidate to mitigate interest rate risks, with the outlook for the asset class buttressed by subdued default risks, stronger fundamentals and supportive capital market conditions.
Income-seeking investors should also consider embracing some equity risk to enhance portfolio yield. No matter the view on inflation and interest rates, the general truism remains – returns from bonds are capped on the upside by the yield of the bond while returns for equities, whether by capital appreciation or dividends, are virtually uncapped. Adopting a multi-asset approach by including healthy dividend growers in the mix helps widen the opportunity set for yield enhancement.
Curb your enthusiasm
Yet, investors should not compromise robust risk management in the fervent pursuit of income. It is still prudent to have some allocation to high quality bonds that can act a bulwark against potential equity market selloffs or deteriorating market conditions. Active management will also be key to navigate a potentially rocky market terrain ahead, especially in a year of major transitions.
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