Most investors are more familiar with equities but bonds are where they should be focusing their attention at the moment. Morgan Stanley analysts believe the near-term outlook for bonds is very attractive – we look at why.
For investors who are less familiar with bonds, some of the terminology can seem daunting.
One of the most important concepts is the relationship between yields and prices. The yield (expressed as an interest rate) on a bond is the inverse of its price. If yields are falling, prices are rising. And vice versa.
With that out of the way, let’s get into the views of Morgan Stanley’s analysts.
Our analysts expect to see bond yields decline throughout 2023. Their view is that inflation will moderate, economic activity will soften and unemployment will rise. This will lead the Federal Reserve to pause rate hikes early in the year and potentially move to cuts later in the year. Declining bond yields means rising prices and therefore positive returns for investors.
The alternative to this scenario is that the economy remains more resilient than expected. But even if this proves to be the case, our analysts see little need for the Federal Reserve to raise rates beyond 5.0%, which is already largely priced into bonds. This means bond yields are unlikely to increase significantly and prices will be relatively stable.
The asymmetric nature of these outcomes makes bonds currently quite attractive. If things go as expected, the upside will be significant. If things don’t go as expected, the downside is likely to be limited.
We see the key drivers of the upside in bond yield reverting in the months ahead:
- Purchasing managers index
- Quantitative tightening
- Aggressive rate hikes
After remaining stubbornly high for much of the year, the US consumer price index (CPI) for October came in sharply below expectations. This softening of core inflation in October is welcome news for the Federal Reserve and policymakers have indicated they are likely to moderate the pace of rate rises. Morgan Stanley believes inflation will continue to normalise over the course of 2023, which is positive for bonds.
To date, US employment has remained remarkably robust and this is the main impediment to yields declining in 2023 as our analysts are expecting. Having said that, they believe the effects of monetary tightening will feed through to the real economy and expect to see the US unemployment rate rise gradually throughout 2023 (to 4.4%). Rising unemployment should contribute to the normalisation of inflation outlined above.
While the US ISM Manufacturing Purchasing Managers Index (PMI) hasn’t yet fallen into contraction territory, the sub-indices within it have already displayed weakness. These leading indicators suggest that the broader index is likely to dip below 50 in the next couple of months. A reading below 50 indicates that the manufacturing economy is generally declining. Other key indicators (the Duncan Leading Indicator and the Conference Board Leading Economic Indicator) are likewise suggesting challenging economic conditions ahead. A slowing economy again reduces pressure on prices.
The Fed started passive quantitative tightening (QT) in June of this year and stepped up the pace in September. We believe at this stage that QT will continue at its current pace through the second quarter of 2024, although downside risks on the economy could see the end of QT be brought forward. The expectation that the downward pressure on bond prices from QT could end sooner than expected is positive for bonds.
This rate hike cycle has been one of the most aggressive in history. Our analysts believe we could start to see a reduction in the pace of rate increases as early as December. If this eventuates, we expect rates to peak early in 2023 (at 4.4% in the US and 3.6% in Australia) and move lower gradually over the course of the year, led by declining 2-year yields.
This outlook for weaker growth and inflation next year makes government bonds more attractive in a multi-asset portfolio context given:
- the current higher starting 10 year Treasury yield of ~4.0% in both Australia and the US
- restored diversification benefits.
This is why we have been rebuilding the fixed income allocation in our recommended portfolio positioning in recent months, with our portfolios now showing a modest overweight position.
For more on Morgan Stanley’s outlook for 2023, speak to your Morgan Stanley financial adviser or representative.