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    GSAM Insights

    BRING ON BONDS

    Fixed Income Outlook | Q1 2023

    January 3, 2023  |  8 Minute Read

    Sam Finkelstein

    Chief Investment Officer, Fixed Income and Liquidity Solutions

    Sam Finkelstein

    Whitney Watson

    Global co-head of Fixed Income and Liquidity Solutions

    Whitney Watson

    Fixed Income Perspectives

     

    Over the past couple of years, a confluence of factors—a global pandemic, surging inflation, war in Europe, aggressive monetary tightening and a cost-of-living crisis—has rocked the boat for investors like never before. In 2023, we think some—but not all—of these headwinds will begin to abate. We expect a slowdown in growth but also in inflation and the pace of monetary tightening. However, risks to our outlook are skewed in a negative direction, primarily because the timing and magnitude of improvement in inflation is uncertain. This points to the prospect of an extended monetary tightening cycle, which combined with the lagged impact of prior rate hikes suggests recession risk is high. But amid high uncertainty and mixed signals from economic data one thing is clear: it is time to bring on bonds. We believe the sharp rise in yields in 2022 presents fixed income investors with the most attractive income and total return potential in more than a decade. Today’s backdrop reflects a material change to the post-global financial crisis cycle, which was dominated by TINA (There Is No Alternative) when low bond yields led investors up the risk curve. In the near term, we favour short duration and high quality fixed income assets like investment grade credit and agency mortgage-backed securities (MBS). As evidence of normalising inflation and growth improvements becomes clearer, we think there will be an opportunity to add exposure to cyclical assets such as high yield credit and emerging market (EM) debt.

     

    "Yields are at a decade high, creating – in our view—an exceptional environment for generating high single-digit returns from high quality fixed income assets such as agency MBS and investment grade credit—even as inflation uncertainty and recession risks linger. More broadly, we think higher yields represent a good entry point for strategic investors in all fixed income markets, including EM debt where idiosyncratic risks have overshadowed broader resilience.”

    – Sam Finkelstein, Chief Investment Officer, Fixed Income and Liquidity Solutions.

     

    “We think 2023 will be an opportunistic environment for fixed income investors. But the era of ultra-easy policy is behind us, and we expect greater dispersion as borrowers adapt to slower economic and earnings growth, as well as a higher-for-longer inflation and rate environment. This underscores the importance of a dynamic and selective investment approach, including towards the growing universe of green, social and sustainable bonds.”

    – Whitney Watson, Co-Head of Fixed Income and Head of Fixed Income Portfolio Management, Construction & Risk.

    Macro at a Glance

     

    Growth

    We think the US will achieve a soft landing given the strong starting point for the labor market and private sector balance sheets. That said, monetary tightening is starting to take hold on the economy, primarily the housing market, and the lagged impact of prior tightening suggests risk of recession is high. Europe is likely already in recession, but the downturn may be shallow given fiscal support, resilient labor markets and mild weather (which lowers the risk of severe energy rationing this winter). But we also expect a muted recovery given ongoing energy challenges. Meanwhile, gradual reopening of the Chinese economy in 2023—a helpful development for domestic growth, global supply chains and key trade partners such as Europe—will likely be bumpy given the risk of rising cases and consumer caution.

     

    Inflation

    In 2022, inflation turned into a persistent, double-digit problem as prices for everything from gas to groceries and haircuts to hotel stays surged higher. But after a year of aggressive monetary tightening and as supply bottlenecks clear, the hope is that inflation continues the process of normalization in the coming months. However, the timing and magnitude of the improvement in inflation is still uncertain. The risk is that tight labor markets fail to relieve pressure on wages and services prices. Fresh supply shocks, particularly for commodities, are also a possibility. Even as the economy rebalances, inflation will likely settle at higher levels due to structural forces. For example, global trade is shifting to be less driven by cost and efficiency, and more by considerations of national security, supply chain resilience and sustainability. Meanwhile, geopolitical volatility is already creating cost-push inflation.

     

     

    Source: Macrobond, Goldman Sachs Asset Management. US reflects core PCE inflation. Euro area and UK as of November 2022, US and Japan as of October 2022.

     

    Medium-Term European Inflation Signposts Shift Higher

    Source: Macrobond, Goldman Sachs Asset Management. Wages reflect compensation per employee. As of Q3 2022.

    Policy Picture

     

    Rate Hikes Step Down a Gear

    Central banks remain committed to taming inflation but are swapping front-loaded tightening for “more ordinary” rate hikes in the words of St. Louis Fed President James Bullard. But with inflation still well above its target, a slower pace of tightening will likely be accompanied by a longer hiking cycle to a higher terminal rate. Nonetheless, this new phase of monetary tightening lowers the tail risk of over-tightening which may help to lower interest rate volatility. The ECB will start quantitative tightening (QT) in 2023 but like the US and UK, the market implications will depend on the prevailing investment environment and fiscal policy.

     

    Fiscal Loosening to Avoid Energy Austerity

    Following measures to cushion the impact of the energy price shock in 2022, we think the fiscal stance in Europe and the UK will normalize in 2023. That said, risks are skewed towards looser fiscal policies over the coming years as governments respond to a range of challenges including ageing populations, decarbonization and destabilization in geopolitics (which is bringing spending on defence and supply chain resilience into focus).

     

    2023 Wildcard – the Bank of Japan

    Japan has been an outlier on inflation and policy for many years but may be on the verge of convergence with the rest of the world, sending calls for “Japanification” of major economies elsewhere into retreat. Inflation has taken off and news reports suggest there are plans to increase defence spending. In 2023, wages—which have yet to rise—will be key to the inflation outlook alongside inflation expectations which still fall short of 2%. As the BoJ joins other central banks in tightening policy, the resultant rise in global bond term premium could see high volatility return to rate markets.

     

    From Expeditious Rate Hikes in 2022 to “Ordinary” Tightening in 2023

    Source: Macrobond, Goldman Sachs Asset Management. Wages reflect compensation per employee. As of Q3 2022.

     

    Europe Delivered 2.5% of GDP in Energy-Related Fiscal Support in 2022¹

    Source: Macrobond. As of November 2022. ¹Goldman Sachs Global Investment Research European Economics Analyst The Permanent Cost of the Energy Crisis (13 November 2022).

    What to Watch

     

    The Labor Market

    Rebalancing of the labour market—largely through a decline in job openings rather than layoffs—is key to easing pressure on wage growth, and in turn core services inflation, while avoiding a severe recession. This would be historically unprecedented but is plausible given the unique features of the post-pandemic recovery. The US has made some progress but still has a long way to go. The Euro area labour market is also overheated, while the UK faces structural labour supply challenges from an ageing population, low net migration, higher early retirement and an increase in long-term sickness.

     

    Supply Constraints

    A recurring theme of the post-pandemic economy is robust demand coming up against supply constraints in everything from food to fuel and semiconductor chips to used cars. In 2023, China’s exit from Zero-COVID policies may add to imbalances in supply-constrained commodity markets (see Chart).

     

    Financial Stability

    Aggressive monetary tightening and the prospect of a higher-for-longer rate regime raises financial instability risks. For example, QT could exacerbate already poor liquidity conditions in the US Treasury market. Meanwhile, slower growth and higher rates could see fragmentation concerns return to the Euro area, particularly in highly indebted Italy. A higher cost of capital could also create challenges among corporate borrowers. For example, the floating rate nature of leveraged loans means that the impact of a higher funding cost environment will be felt swifter by loan-only issuers, irrespective of their near-term refinancing needs, and even if some of the floating rate exposure is hedged. We will be paying close attention to potential pockets of vulnerabilities in 2023.

     

    Limited Inventories Creates Upside Risks for Commodity Prices

    Source: Bloomberg, USDA, EIA, Wind, Goldman Sachs Global Investment Research. As of November 2022.

     

    Unemployment Remains Historically Low

    Source: Macrobond. Based on data released as of December 13, 2022.

    Navigating Fixed Income

     

    Macro Markets

     

    Interest Rates

    Outlook: We think a shift in risks from rising inflation to weaker growth combined with a slower pace of tightening should allow core government bonds to deliver positive total returns in 2023. In the near term, we remain alert to upward pressure on bond yields from an extended tightening cycle.

     

    Positioning: We are underweight Japanese rates as we think rising domestic inflation pressures, including firmer wages, will likely lead the BoJ to retreat from ultra-easy policies. Elsewhere, we are positioned for rate volatility to ease from high levels seen in 2022. We are also modestly underweight European rates as we see potential for a longer ECB rate hiking cycle given upside risks to European inflation from energy supply challenges.

     

     

    Currencies

    Outlook: Even with the recent retracement of the US dollar, many currencies look undervalued relative to the greenback. The dollar could strengthen further if the Fed tightening cycle extends or if recession and financial instability risks materialise given the dollars perceived safe-haven status. That said, at some point in 2023, conditions for a sustained turn in the dollar could fall into place, namely, a pause in Fed hiking and a trough in global growth.

     

    Positioning: We hold modest exposures given mixed macro and market signals. We are slightly underweight the US dollar and European currencies such as the British pound and Swedish krona, while overweight developed market commodity-oriented currencies and low-yielding Asian currencies.

     

    Goodbye Negative Yielding Bonds

    Source: Macrobond, Bloomberg. As of November 2022.

    Navigating Fixed Income

     

    Spread Sector Asset Allocation

     

    Fixed Income Spread Sectors

    Outlook: Given economic uncertainty, we think the first part of the year favors a defensive and up-in-quality bias among fixed income spread sectors.

     

    Positioning: We are overweight investment grade (IG) credit and agency MBS as well as high-rated securitized sectors, while moderately positioned in high yield (HY) credit and EM debt.

     

    Balance¹

    Outlook: Government bonds have typically been a source of balance in multi-asset portfolios, offsetting weakness in assets such as equities and credit during risk-off episodes. The negative correlation between bonds and risk assets held relatively steady in the last cycle, and in general since the 1990s, due to rate volatility largely being driven by growth volatility, while inflation remained in check. The pandemic disrupted this set-up. High inflation volatility coupled with a broad and swift global monetary tightening cycle generated sharp weakness in both bonds and risk assets in 2022. In 2023, two key developments could help the balance—or hedging—properties of bonds improve. First, historical evidence suggests that normalising inflation is consistent with the correlation between bonds and risk assets turning less positive, and eventually negative. Second, higher yields mean bonds have more room to rally and cushion weakness from equities or credit. This marks a change from the post-global financial crisis period when low yields limited the ability of bonds to buffer declines in risk assets.

     

    Positioning: We are currently balancing around 40% of our exposure to fixed income spread sectors with rates in multi-sector fixed income portfolios. In unconstrained fixed income portfolios, this ratio is around 60%.

     

    Attractive Total Return Potential From Higher Yields

    Source: Macrobond, Goldman Sachs Asset Management. As of December 15, 2022.

    Central Bank Snapshot

    Source: Goldman Sachs Asset Management. As of January 3, 2023. Abbreviations: Quantitative Easing (QE), Quantitative Tightening (QT), Yield Curve Control (YCC), Pandemic Emergency Purchase Program (PEPP), Asset Purchase Program (APP). 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 of this document.
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    Fixed Income Outlook | 1Q2023: Bring on Bonds

     

     

     

     

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    ¹Balance exposure is as of January 4, 2023. We seek to bolster resilience of portfolios to uncertainty and tail risks over an investment cycle by pairing spread sector exposures with interest rates and developed market currencies, or some combination of both. These assets can provide balance as they typically exhibit a negative correlation with spread sectors. See “ Fixed Income Asset Allocation: A Well Balanced Approach ” for details.
    ²12-month trailing issuer weighted default rate, Source: Moody’s, Standard and Poor’s, Haver Analytics, Goldman Sachs Global Investment Research as of November 2022.
    ³Source: Goldman Sachs Global Investment Research 2023 Global Credit Outlook: There will be yield as of November 16, 2022.

    Risk Considerations

    The risk of foreign currency exchange rate fluctuations may cause the value of securities denominated in such foreign currency to decline in value. Currency exchange rates may fluctuate significantly over short periods of time. These risks may be more pronounced for investments in securities of issuers located in, or otherwise economically tied to, emerging countries. If applicable, investment techniques used to attempt to reduce the risk of currency movements (hedging), may not be effective. Hedging also involves additional risks associated with derivatives.

    Investments in fixed income securities are subject to the risks associated with debt securities generally, including credit, liquidity, interest rate, prepayment and extension risk. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline in the bond’s price. The value of securities with variable and floating interest rates are generally less sensitive to interest rate changes than securities with fixed interest rates. Variable and floating rate securities may decline in value if interest rates do not move as expected. Conversely, variable and floating rate securities will not generally rise in value if market interest rates decline. Credit risk is the risk that an issuer will default on payments of interest and principal. Credit risk is higher when investing in high yield bonds, also known as junk bonds. Prepayment risk is the risk that the issuer of a security may pay off principal more quickly than originally anticipated. Extension risk is the risk that the issuer of a security may pay off principal more slowly than originally anticipated. All fixed income investments may be worth less than their original cost upon redemption or maturity.

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    Index Benchmarks

    Indices are unmanaged. The figures for the index reflect the reinvestment of all income or dividends, as applicable, but do not reflect the deduction of any fees or expenses which would reduce returns. Investors cannot invest directly in indices.

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    302127-OTU-1720035. Date of first use: December 19, 2022.

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