After a forgettable 2022, equity and bond markets have had a more favourable beginning to 2023 as the economy has remained strong and inflation appears to be easing. In the United States, the world’s largest financial market, inflation (as measured by the Consumer Price Index, or CPI), has fallen from 6.5% year-on-year (YoY) at the beginning of 2023 to 4.9% YoY in May.
In Australia, annual CPI has also been trending down this year, falling from 8.4% YoY in December 2022 to 6.8% YoY in April 2023. Unfortunately these are still relatively high numbers, and both the Federal Reserve and Reserve Bank of Australia (RBA) have continued to raise interest rates, with the federal funds rate and overnight cash rate now sitting at 5.25% and 4.10%, respectively. The good news is that the end appears to be in sight (at least in the US), with the majority of economists and major banks now anticipating that the peak of the interest rate tightening cycle could arrive by the end of 2023–which should be an especially great relief to mortgage-holders.
The even better news is that despite the most aggressive rate hiking cycle in 40 years, both the U.S. and Australian economies are holding up relatively well. The major casualty has been the US banking sector, a story that we’ve covered previously and that will continue to play out over the next 6-12 months. This does not appear to have materially slowed the economy yet, however, with the US Bureau of Labor Statistics revealing a further 339,000 jobs had been added to the US economy in May. This blockbuster result saw substantial hiring in business services, healthcare and hospitality, and far exceeded Wall St expectations of 195,000–not to mention the 90,000 monthly additions that are required to hold the unemployment rate steady. Job vacancies also remain high in Australia at 438,500 (at the end of February, the most recent release from the Australian Bureau of Statistics), which recently supported a 5.75% bump to the minimum wage. House prices in both the U.S. and Australia have also held up remarkably well despite the affordability challenges of higher interest rates, supported by low inventory levels, rising rent prices, and record levels of migration.
Number of Job Openings (000s) in the United States
A New Era for Bonds?
Until 2022, the bond market experienced a more than 35-year decline in the yields on fixed income investments. While this was great for investors who already held long-term fixed income securities (bond prices increased as the yields declined, an inverse relationship presented in the chart below), there were limited opportunities for new investors looking to lock in reasonable rates of return. Following the dramatic interest rate cuts and financial stimulus that central banks implemented at the beginning of the pandemic, investors were struggling to get more than 2% on any government (or even corporate) bond. During the 1980s, by contrast, investors could lock in 15% yields on long-term government bonds for 30 years, with little to no risk of not being paid. While at the time investors were uncertain that this would turn out to be a good investment given rampant inflation, those who took advantage of this outperformed most other asset classes, including the S&P 500, which returned around 10% per year.
The market headlines will say that last year the bond market endured its worst year in more than 200 years and that investing bonds didn’t provide investors the diversification they were looking for. According to traditional investment theory, bonds are supposed to provide some diversification for equity investors, moving in the opposite direction or providing stability in a more volatile market. This wasn’t the case in 2022, however. The Bloomberg US Aggregate Bond Index (a proxy for the US bond market) declined 13% in 2022, and with the S&P 500 also falling 18%, this was the first time since 1969 that both indexes had suffered double digit losses. The extreme pace of rate rises simply hammered low-yielding bonds, an impact starkly seen in the U.S. banking crisis and even more so for investors holding sovereign debt that just a few years ago sported a negative interest rate.
From Crisis Comes Opportunity
Amongst these gloomy headlines, there’s good news for prospective investors looking to add some secure income to their portfolio. While the bond yields of 2023 are nowhere close to the 15% offered back in the early 1980s, they are significantly more attractive than they’ve been for quite some time. Today, investors can earn more than 5% in U.S. treasury bills that mature in less than one year–providing a healthy return with a lot of flexibility and very little chance of not being repaid, with U.S. government bonds carrying a AAA rating and having never defaulted.
Short-term government bonds look the best bet at this stage, given the seemingly low likelihood of interest rate cuts this year and the inverted yield curve (meaning that longer term bonds currently have lower yields than shorter term bonds). In fact, the U.S. 10-year government security currently yields just 3.71% compared to the 1-year bond of 5.18%. An inverted yield curve usually suggests that the central bank is likely to cut the benchmark interest rate in the near future, which would reduce short-term bond rates (because, theoretically speaking, longer-term bond rates should normally be higher).
This is certainly the current narrative of the media and the finance industry, but with the economy still looking strong, particularly employment, the risk to interest rates appears to be higher rather than lower. And if the Federal Reserve keeps interest rates steady or even increases them, there’s likely to be even better opportunities for both short and long-term bonds in the next 6-12 months–at which time a bond bought soon will be maturing and the funds ready to redeploy.
An Opening Window
2022 was a tough year for investors of almost all stripes, with the illusion of diversification dispelled and both equities and bonds falling double digits. Despite the “wall of worry” that often occupies the financial media, the outlook for 2023 appears brighter, with the economy soldiering on and job openings at near-record levels.
Combined with a softening inflation outlook, this is a healthy recipe for investment returns, and in particular, bonds. While fixed income yields had been in a steady state of decline for more than 35 years, the fastest pace of interest rate increases in 2022 may have punished existing bondholders, but provided a great opportunity for new investors. Tamim will shortly be launching a new SPV which will have focus on a portfolio of bonds. The idea being not only will you earn interest on the portfolio on a quarterly basis but you could also potentially earn capital gains in a scenario where central banks are forced to lower rates in responses to a slowing economy. If you have any interest in this conservative, yet high potential investment, please register your interest below.
Markets & Commentary
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TAMIM Asset Management provides general information to help you understand our investment approach. Any financial information we provide is not advice, has not considered your personal circumstances and may not be suitable for you.