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The past year has been challenging for global bond markets. Alexandra Gorewicz, Portfolio Manager, Active Fixed Income at TD Asset Management, tells Greg Bonnell that the year ahead may see a return to stability for bond markets, which may mean opportunities for investors.
Transcript
Greg Bonnell: It’s been a tough year for investors. Not many places to ride out the volatility, but as central banks get closer to the end of this rate hiking cycle, could there be opportunities ahead in fixed income? More on this, we’re joined now by Alex Gorewicz, portfolio manager for active fixed income at TD Asset Management. Alex, great to have you back. Always a pleasure to have you on the show.
Alexandra Gorewicz: Thanks, Greg. Great to be here.
Greg Bonnell: So we’re going to say goodbye to 2022, and it’s probably sooner than we think. December is just around the corner. We think about all the turmoil of the year, the central banks’ super-sized rate hikes. One would hope we’re at least closer to the end than we were a while ago. What does it mean for fixed income in 2023?
Alexandra Gorewicz: Hopefully, it means more stability. And I mean, part of that is because of, let’s say, a slower pace of rate hikes that we expect central banks to deliver. But really, the reason they’re able to slow down their pace of rate hikes is because inflation appears to be turning the corner, and inflation will be the key to watch. And we think, especially in the first quarter, perhaps first half of the year, that’s when we’ll see the biggest sort of gains in normalization and inflation, in other words, coming back down towards 2%. We’ll see more normalization, and then that enables bonds to behave more bond-like.
Greg Bonnell: More like bonds.
Alexandra Gorewicz: More like bonds, that’s right. I mean, it’s been a very difficult year for all asset classes, as you’ve alluded to. And it’s because inflation has been not just high but rising. That’s a bad environment for bonds, and that’s not what we expect for next year.
Greg Bonnell: So if we expect, perhaps, bonds to start behaving more like bonds next year as we sort of work our way through inflation and all these rate hikes, can we have some faith again, perhaps, in the 60/40 portfolio? I think that called into question this year, because usually, you’re like, okay, in times of turmoil, maybe my equities aren’t looking great. But I’ve got this portion of bonds on my portfolio. So I’ve got a bit of safety here, a bit of a haven, but it wasn’t a haven this year just because of the mechanics of why the market was selling off.
Alexandra Gorewicz: That’s right, but there’s an element to that safety component. Bonds tend to do well when the economy is slowing down and when inflation is not a problem. Now, the fact that inflation was a problem this year and nothing worked for us meant eventually inflation would lead to a slowdown in growth. Consumption would have to start slowing down as people would ration their budgets towards the necessities, not the nice to haves. And we’re starting to see evidence of that happening. If we look at the quarter-over-quarter trend in consumption this year in the US, which is arguably the most resilient economy at the moment, we’re seeing that downward trajectory in consumption. And that tells us that — partially that inflation has not been kind to the economy, but that, looking forward, as companies now will struggle how to manage those costs that they’ve incurred, it will likely mean slower economic growth. And that’s usually when bonds do well. So if you couple slower economic growth with less inflation problems for 2023, it should mean bonds can have that safety feature again in a 60/40 portfolio.
Greg Bonnell: Now, when we take a look at the fixed income environment right now, we’re also seeing something that we’re not accustomed to seeing, which is yield and fairly substantial yield compared to what we have been used to for a good many years.
Alexandra Gorewicz: That’s right. So talking about bonds being that safety component, you would think, interest rates will go down, so bond prices will be going up. In other words, you’re getting positive returns from fixed income. But even if that doesn’t happen — let’s say we avoid a recession, let’s say things sort of move sideways and inflation just comes down — it means stability in interest rates. It means that we won’t see interest rates move materially in one direction or another. So then yield is really just a proxy for the income that you’re getting from the asset class. And if you look at a typical, let’s say, Canadian Bond Fund, it’s about 5% yield. That’s good income that we have not been accustomed to for a decade plus.
Greg Bonnell: Now, what could knock us off track for a 2023 that’s a little more favorable for fixed income than it was this year? Would it just be the — I mean, a deeper sense, it’s strange, the mechanics here. The central banks have been trying to slow the economy. They think the labor market is too hot. They want to see a bit of pain out there. How does pain translate into fixed income portfolios?
Alexandra Gorewicz: Well, so part of the challenge right now is when we talk about the trajectory for inflation going down, but the level still matters. And the level is still substantially higher, at least at this time, than where central banks are targeting for inflation to be, which is, let’s say, 2%. So the fact that inflation is above that target means that central banks can’t cut interest rates. So if you look at shorter-dated bonds, so let’s say zero to five years, those yields will likely stay high. But if we get a deeper recession, longer-dated interest rates or longer-dated bonds respond more to a mix of both monetary policy as well as economic developments. So those interest rates will likely come down. And we’ve seen a glimpse of that over the last month or so. As central banks have started slowing the pace of their rate hikes, the front end of yield curves have remained sort of sticky high in terms of interest rates, but longer-dated interest rates are now responding to economic data coming in, which is pointing towards a slowing in the coming quarters. And so interest rates have come down at longer end of the yield curve.
Greg Bonnell: There’s not complete agreement out there, but we have a fairly good idea of what the terminal rate will look like in this cycle for various central banks based on projections, what the central banks have said themselves. That’s just the end point of this hiking cycle. Do we have any idea going forward what normal interest rates look like, or will there ever be such a thing again?
Alexandra Gorewicz: Yeah, that part’s harder. So the reason that part’s harder to gauge is there are a number of factors at the moment that suggest inflation, it could normalize, but it could normalize to a level that’s higher than what we’ve been used to, at least before the pandemic. So if we look at various geopolitical factors, if we look at the policy response from individual governments after the pandemic and all the global supply chain disruptions, you’re seeing signs that governments want to build what they call resilience in their economies. So in other words, make sure that we have certain key industries or certain key goods and services that are produced locally that will require a lot of investment. Well, all that investment will very likely mean prices could be stickier or higher in the long run. And when I say long run, I mean we could say anywhere between one to two years looking out. So even if inflation, as we expect it to normalize in the coming quarters, does come down, the question is, does it come down to 2%, or does it come down to something a little bit higher? And at the moment, the evidence is pointing towards a little bit higher. If that’s the case, it means, sure, interest rates can normalize. Maybe we don’t stay at 4% or 5% forever, but will they go back down to zero or 1%? That’s unlikely in the next couple of years.
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