So far this year, global fixed income markets have been dominated by rising inflation and relatively hawkish central banks. So, as we look to the second half of the year, what’s next?
There is increased investor uncertainty amid the backdrop of higher interest rates, meaning investors are being more selective in their choices. For credit investors this means a renewed focus on balance sheet strength and flexibility. We think H2 will be marked by a delicate balance of opportunities and challenges.
Despite better-than-expected growth in H1, we expect a slowdown in H2 as central banks grapple with sticky inflation. On the positive side, energy prices are adjusting down, and input prices are moderating however core inflation is still elevated, and we do not see a premature end to the current rate hike cycle from the European Central Bank (ECB). While we believe the majority of interest rate rises have been implemented, we still expect further increases in the coming months.
Inverted yield curves imply a high risk of recession in the euro area. However, at the same time stubbornly high inflation points to a risk of stagflation. To fight these risks, central banks need to both increase interest rates further and continue the process of reducing bloated balance sheets. The Bank of England started to divest their portfolio in November 2022 and the ECB committed to tapering in March this year. We expect the Fed to look for opportunities in 2023. While the developments are welcome, they are not without risk, significant care will need to be taken not to disrupt markets and execution will be extremely challenging.
The turbulence in the banking sector in H1 has shown just how destabilising rate rises can be after a long period of very low interest rates. Despite the failure of Credit Suisse, we believe larger European and Irish banks are well positioned with high liquidity ratios and robust capital levels.
Our view is that market volatility will remain for the rest of the year and possibly into 2024. Risk assets look attractive, as most rate rises have been priced into asset values. However, investors should be mindful that rates may be elevated for an extended period and caution is required with this continued uncertainty.
What looks good?
- We like the short end of the government bond markets however we can see an opportunity to extend the duration as we reach terminal rates.
- Infrastructure assets are attractive as they can provide stable income streams and inflation protection, serving as a hedge against inflation revival.
- Green Bonds are becoming more prevalent. Investors are increasingly incorporating ESG factors into their investment strategies and decision-making processes and therefore there is a continued onus on issuers to display their ESG credentials. Irish banks have been central to this with AIB recently voted the most impressive Financial Institution ESG Bond Issuer at the Global Capital Bond Awards 2023.
- Investment grade credit and national champion bank paper.
- Something to look out for is refinancing risk in the high yield market and the Commercial Mortgage-Backed Securities (CMBS) market, in particular US CMBS.
In conclusion, the remainder of 2023 will not be straightforward, opportunities will present themselves. It will be key for investors to remain agile.
Garret Grogan, Head of Fixed Income Trading
T +353 1 641 9002 E [email protected]
T+353 1 641 9236 E [email protected]
Thomas Duffy, Fixed Income Trader
T +353 1 641 9084 E [email protected]