Flat Quarter, Down Year
The Bloomberg Barclays Aggregate Bond Index finished the fourth quarter with a near-zero return of +0.01%. Investment grade corporate bonds posted their second consecutive quarterly loss versus Treasuries despite the S&P 500 finishing at all-time highs. Corporate bonds had their worst quarter since the first quarter of 2020 but still managed to outperform Treasuries on the year by more than 150 basis points. Mortgage-backed securities posted their worst excess return year since 2011 and underperformed Treasuries. In summation, it wasn’t the smoothest ride for fixed income in 2021, and the Bloomberg Barclays Aggregate Bond Index fell 1.5%. It was the worst annual return since 2013.
The highlight of the quarter was the Federal Reserve’s hawkish pivot in which they acknowledged that inflation was more persistent than they originally anticipated. They increased the speed of the balance sheet tapering which opens the window for faster rate hikes. We began the quarter with the market pricing in only one interest rate hike in 2022 and ended with three implied hikes. Despite this, the market is pricing in another lower peak in the terminal rate this cycle.
We see the global growth story in 2022 failing to meet consensus expectations. The recent surge in consumer spending likely contained large elements of demand pull-forward, which are not being helped by falling real incomes. Fiscal impulses are rolling over significantly with their impacts to be felt in the first half of next year. We are also in a period of rising oil prices, rising short-term interest rates and a rising dollar. This has historically been a lead indicator of earnings estimates falling in a pronounced manner.
We don’t think the Federal Open Market Committee (FOMC) will be able to meet the market expectation of three hikes next year in the face of slowing global growth. They may try, which we expect to be met with falling long-term bond yields. The consensus is still that growth will be strong in 2022 and thus a hawkish Fed is a bit of headwind, but nothing to be worried about given the historical returns early in hiking cycles. What could change in 2022 is what the Fed does, should slower growth and earnings downgrades become embedded. Inflation will still be high given its lagging effects and they will need to either look forward or backward. And to complicate things, this will all take place in an election year.
We anticipate things to get a bit rocky as we near the January FOMC meeting. The Fed’s reaction function remains the biggest factor in markets. We would expect a consistent hawkish message to be a headwind to corporate bonds and help keep long yields low in the first quarter. Absent a massive, unexpected government spending measure out of the U.S. or China, we think the Fed will be forced to either fight inflation or pivot to help struggling risk assets as the year progresses. The impact on markets is a complete 180-degree difference depending on which path the Fed chooses. And of course, the timing will be anything but predictable. Against this backdrop we hope to continue to produce consistent returns by focusing on risk, being openminded, and anticipating narrative shifts.
Source: BTC Capital Management, Bloomberg LP, Ibbotson Associates, FactSet, Refinitiv.
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