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Wealth Insights | Bonds

Why We Believe Bonds are Back

The global economy has endured a series of severe, unusual, and unexpected shocks over the past three years. COVID shutdowns, unprecedented stimulus, snarled supply chains and Russia’s invasion of Ukraine have all created significant challenges for consumers, businesses, and governments. The most obvious result of these shocks is inflation. Across developed economies, consumer prices have been rising faster than they have in decades. In response, policymakers are withdrawing the fiscal and monetary boost they provided when COVID struck. And now they are turning their attention to “fighting inflation” with urgency.

The US Federal Reserve is leading the inflation fight, having pivoted from easing to a fast rate of upward interest rate adjustments and a reduction in its balance sheet. CIO thinks there’s a clear danger the Fed will go too far. The global economy is already slowing as high inflation and less stimulus hit consumer spending. CIO now forecasts global growth of around 2.6% in both 2022 and 2023, about 1% lower than our previous expectations.

  • If the Fed is successful, reducing inflation while not causing a recession, we expect low single-digit gains for global equities and bonds through the end of 2022. If the Fed is unsuccessful and constrains growth too quickly or reduces liquidity too severely, a recessionary scenario can unfold with more severe consequences for equities. While Citi’s base case is that the expansion will endure, our analysts see the risk of US recession as higher than usual in 2023 (35%). This is a material risk.

  • One of CIO’s key calls focuses on high quality fixed income. In CIO’s view, there are compelling potential opportunities to bring high-quality bonds back into portfolios. In 2022, bonds have suffered a brutal run, selling off hard on monetary tightening fears. As their prices have gotten crushed, yields have risen substantially. Given this uplift in yields, CIO believes many high-quality bonds can again produce portfolio income and diversify equity risk. Investors don’t agree with Citi’s view just yet: Bond mutual funds and ETFs have averaged net outflows of $1.8 billion over the last four weeks.

Chart: Bond Mutual Fund and ETF Flows (4-week average)

Portfolio Considerations

  • In CIO’s view, most of the expected US tightening is now embedded in Treasury yields. CIO believes rates will peak this year, as US GDP growth decelerates rapidly. In turn, this will likely see a slow reduction in inflation readings, perhaps allowing the Fed to relax its hawkish stance by late 2022. For investors, these higher yields may represent an attractive level at which to buy. CIO thinks that certain fixed income assets now offer an “antidote” to the “cash thief,” given their higher yields.

  • What’s more, such assets may also help mitigate equity risk within a diversified portfolio. Historically, long-term US Treasuries are one of the few assets with a negative correlation to equities during large equity corrections. However, CIO emphasizes the need for selectivity here. Neither long-dated European and Japanese government securities nor “risky credit” have the same historical hedging properties. This is due more to active central bank intervention in those regions and because “risky credit” returns tend to track equity returns. The opportunities CIO has identified in fixed income include high quality bonds, portfolio diversifiers, and structured investments.

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