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    Fixed Income Outlook 3Q 2022

    Navigating Expeditious Tightening

    Heading into the third quarter, inflation will likely remain at the root of market volatility. With central banks getting tough on inflation, prospects of a soft landing are reduced and the risk of a hard landing or stagflation scenario is heightened. There are two key areas to focus on to gauge progress on inflation being brought back under control.

    First, signs of softening in the labor market, either through a decline in job openings or a moderate decline in employment. Second, a decline in consumer and business inflation expectations, for which commodity inflation is particularly salient. In navigating an expeditious monetary tightening cycle, we hold moderate exposure to macro markets and remain overweight spread sectors that provide attractive carry and roll¹. Overall, high uncertainty underscores the importance of being both humble and nimble with our investment views.

    Highlights of the report are below and we encourage you to download the full report for more detailed insights.
    Download Full Report

     

    The economic and market forecasts presented herein are for informational purposes as of the date of this document. There can be no assurance that the forecasts will be achieved.  Please see additional disclosures at the end.

    CIO Perspectives

    Sam Finkelstein

    Chief Investment Officer, Fixed Income and Liquidity Solutions

    Sam Finkelstein

    “Central bank emphasis on data dependence, rather than forward guidance, creates a source of potential market volatility given data is highly unpredictable in this era of supply shocks. But with volatility comes opportunity. We see value in corporate credit and we continue to find relative value opportunities across and within fixed income sectors.”

    Whitney Watson

    Co-CIO and Co-Head, Fixed Income and Liquidity Solutions

    Whitney Watson

    “The recovery coincides with structural shifts such as decarbonization, globalization centred on digital services and destabilization in geopolitics. Some shifts will be reflationary, while others will have a disinflationary effect. Overall, a new economic order has potential to contribute to higher risk premiums in rates and risk assets going forward.”

    Macro at a Glance

    Growth

    Economic activity is expanding but decelerating, particularly in the industrial sector. The service sector recovery is ongoing but may slow given downbeat sentiment (see Chart). We believe the expeditious tightening cycle also adds to downside growth risks through tighter financial conditions. Soft landings are more common when long-run inflation expectations are well anchored and the private sector balance sheet is strong but less common when inflation is high¹. Today’s cycle reflects all three elements, underscoring uncertainty on the economic outlook.

    Downbeat Sentiment May Weigh on Spending and Investment
    US employment cost index, year-over-year

     

    Source: Macrobond, Goldman Sachs Asset Management. US sentiment as of June 2022, OECD country sentiment as of May 2022. The economic and market forecasts presented herein are for informational purposes as of the date of this document. There can be no assurance that the forecasts will be achieved.  Please see additional disclosures at the end.

    Inflation

    Inflation is proving persistent. In the hoped-for soft landing scenario, goods inflation slows on normalizing demand and improved supply (see Chart), a cool down in commodity prices is reflected in lower inflation expectations, and economic growth—which is underpinned by a strong labor market—slows to the extent needed to ease wage growth as companies shelve new hiring plans rather than engaging in layoffs. Prolonged commodity inflation, which is particularly salient for short term inflation expectations, presents upside risks. Longer-term, decarbonization, deglobalization in the flow of goods and labor, aging demographics, digitization and destabilization in geopolitics present mixed inflation implications. But with current data still distorted by supply shocks, we believe it is too soon to conclude whether we are in a new higher inflation and rate regime.

    Rising Inventories Should Support Goods Supply and Ease Goods Prices
    US employment cost index, year-over-year

     

    Source: Macrobond, Goldman Sachs Asset Management. As of May 2022. The economic and market forecasts presented herein are for informational purposes as of the date of this document. There can be no assurance that the forecasts will be achieved.  Please see additional disclosures at the end.

    Policy Picture

    Expeditious Tightening

    The Fed and other central banks were able to keep policy accommodative in the pre-pandemic cycle due to inflation running below the target rate of 2%. Their task now is far more complex as some of the forces lifting inflation—supply disruptions and soaring energy and other commodity prices—are beyond policymakers’ control.

     

    The ECB is on track to exit the negative interest rate policy that was put in place in 2014 by the end of the third quarter. But fragmentation of the currency union remains a chronic issue. A new ECB tool to address future stresses in sovereign bond markets may calm these concerns, though the triggers and features of such a backstop remain unspecified.

    Ain't No Rate High Enough - From 25bps to 50bps to 75bps...
    Central bank asset purchases

     

    Source: Macrobond, Goldman Asset Management. As of June 23, 2022. See Appendix for central bank abbreviations. The economic and market forecasts presented herein are for informational purposes as of the date of this document. There can be no assurance that the forecasts will be achieved.  Please see additional disclosures at the end.

    What to Watch

    Supply and Balance Sheets

    An improvement on the supply side of the economy has potential to alleviate inflation pressures and reduce the degree of monetary tightening required to slow demand by restoring balance in labor markets, housing markets, supply chains and the energy sector.

     

    Household savings rates are declining in part due to high inflation, but the stock of excess savings remains high. We believe US and European corporate balance sheets can withstand macro headwinds. This assessment informs our benign rating downgrade and default outlooks. 

    Savings Rates are Falling but the Stock of Savings Remains High
    Growth Impact of Changes in Financial conditions on annual growth

     

    Source: Macrobond, Goldman Sachs Asset Management. US as of Q1 2022, UK and Euro area as of Q4 2021. The economic and market forecasts presented herein are for informational purposes as of the date of this document. There can be no assurance that the forecasts will be achieved. Please see additional disclosures at the end.

    Related Insights

    ¹ Carry reflects an asset-expected total return (net of financing costs) beyond price appreciation. It is estimated by the yield differential (or ‘spread’) between a fixed income sector and a risk-free asset (typically a relevant sovereign bond yield). Roll refers to a change in spread from “rolling down” a credit curve over time. Our strategic asset allocation models expected returns on carry and roll adjusted for expected downgrade and default activity and seeks to construct fixed income portfolios that optimize carry and roll over a market cycle.

    Abbreviations: Reserve Bank of Australia (RBA), Reserve Bank of New Zealand (RBNZ), Bank of Canada (BoC), Swiss National Bank  (SNB), US Federal Reserve (Fed), European Central Bank (ECB), Bank of England (BoE) and Bank of Japan (BoJ).

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    Date of first use: July 6, 2022 

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