Three factors to drive returns in 2022 - Fixed Income Update - UBS
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UBS Asset Management
For Professional / Qualified /
Institutional Investors only
January 2022
Three factors to drive returns
in 2022.
Fixed Income Update
2022 is shaping up to be a volatile year for financial markets. Last year’s negative returns on benchmark
bond indices such as the Barclays Global Aggregate and AusBond Composite were a result of a slow and
steady realisation that higher-than-expected inflation will require higher interest rates. This year represents
the next phase, with the outlook depending on how far financial conditions can tighten without
jeopardizing the recovery. This is not just the prospect of rate hikes – including from the RBA – but also the
shrinking of bloated central bank balance sheets and negative impulses from fiscal policy.
Initially we think government bond yields will continue to be biased higher. Yet there comes a point where
tighter conditions will collide with overleveraged economies. These episodes are often associated with large
drawdowns in risky asset prices, leaving bonds to once again provide the ballast in investors’ portfolios.
We identify three key factors that we expect to help us generate returns in this turbulent environment:#1 Flexing global rates muscle
A key source of alpha for our funds with global rates flexibility will come from picking the leaders and
laggards in the peloton of global central banks embarking on tightening. Since Q3 last year this has led us to
tactically take short duration positions in UK gilts and US Treasuries. The common thread has been our
expectations that these economies are more inflation prone and our worries that this would become
embedded in inflation expectations requiring a period of central bank catch up. The January post-meeting
press conference from Fed Chair, Jerome Powell, gave the clearest signal yet that the central bank is waking
up to these inflationary forces and is considering rate hikes at greater than the normal 25bp per quarter
increments.
Figure 1: US and UK have been most inflation prone; “low-flation” in Australia about to be
disrupted
5Y inflation
Core inflation* CB inflation Headline CPI BE
latest (%) 5Y avg (%) target (%) latest (%) 3m trend (ann. %) rate (%)
US 4.7 2.0 2.0 7.0 9.2 2.8
UK 4.2 2.0 2.0 4.9 9.6 4.2
Canada 3.7 2.0 1-3 4.8 3.2 2.1
NZ 2.7 1.8 1-3 5.9 5.7 2.6
Australia 2.6 1.6 2-3 3.5 5.3 2.4
Eurozone 2.6 1.0 2.0 5.0 6.6 1.8
Japan -0.7 0.1 2.0 0.8 0.0 0.5
Source UBS: Asset Management, Bloomberg, Note: as of 27 January
New Zealand bonds by contrast look attractive. The RBNZ has gone hard out of the start gate, prompting the
market to already price in an aggressive path of cash rate hikes to nearly 3% next year. The kiwi economy is
likely to be one of the first to experience the impact of tighter financial conditions, and even just a pause in
the hiking cycle should be enough to see bonds rally.
The PBOC is the one central bank running its own race, being in the midst of easing monetary policy. This
has increased the diversification appeal of Chinese Government Bonds whilst, bigger picture, the efficacy of
China’s efforts to re-stimulate credit growth in the wake of renewed COVID concerns is set to be the big
swing factor for global growth this year.#2. Applying lessons from overseas to Australia
Even for AUD-only bond funds, we still think there are gains to be had from watching overseas
developments. For instance our belief is that Omicron will at least temporarily jolt the low inflation consensus
in Australia, which is already showing signs of cracking after a bumper Q4 CPI release. The lesson from
western countries that have been “living with the virus” for some time has been that disruptions to labour
and goods supply have been at least as significant and often longer lasting than the negative impact to
demand.
This will have repercussions for the RBA. In fact, by the time they sit down to meet in May, we suspect
underlying inflation will be at or above 3%, rather than hugging the lower 2% end of the bank’s target
range as they have been forecasting, and wages will also be in a clear uptrend. This will feel uncomfortable
to the doves at the RBA, especially as the Fed will have likely already hiked at least once and domestic QE will
have ended (another lesson from overseas is that the gap between QE ending and rate hikes is narrower
than central banks would have you believe).
The growing likelihood of RBA hikes, likely as early as mid-year, should see upward pressure on Australian
bond yields continue, particularly at the front-end of the yield curve. As we have seen in other jurisdictions,
long-dated bond yields can remain relatively stable even as tightening comes closer into view. Our
expectations is that 10-year ACGBs find support with yields in a 2-2.5% range, and look cheap near the top
of that range on a medium-term horizon based on our assumption that the RBA will ultimately struggle to
raise its cash rate far above 1.5% this cycle.
Figure 2: Long bonds are going sideways even as short yields rise in anticipation of RBA
hikes
3.50
3Y ACGB 10Y ACGB 30Y ACGB
3.00
2.50
Yield (%)
2.00
1.50
1.00
0.50
0.00
Dec-20 Feb-21 Apr-21 Jun-21 Aug-21 Oct-21 Dec-21
Source: UBS Asset Management, Bloomberg#3 Watch real yields
In gauging the point where tighter financial conditions will bite into the outperformance of riskier assets, it is
the inflation-adjusted servicing cost that we need to watch – i.e. the real yield. This is because whereas
borrowers pay a nominal interest rate, inflation serves to reduce the real amount of the future liability.
Specifically it is US real yield that matters most given the majority of global liabilities are denominated in
USD. US real yields are expected to rise this year as global inflation peaks and the flow of central bank QE
stalls or even heads into reverse.
In 2018-19 the Fed paused and subsequently reversed its tightening cycle in response to drawdowns in risky
assets with 10-year US real yields near +1%. The equivalent real yield is -0.54% today but may not have to
rise much further to become a problem given COVID has increased global debt by 38% of GDP (according to
latest BIS data) and many asset classes have been pushed to historically rich valuations. Already a ~50bp rise
in real yields this year has coincided with a more than 10% correction in the growth-heavy NASDAQ index.
Figure 3: Real yields are biting at lower points than in the past
1.50 18000
1.16 10Y US real yield (lhs)
Nasdaq composite index (rhs) 16000
1.00
14000
0.50
Yield (%)
12000
0.00
-0.54 10000
-0.50
8000
-1.00
6000
-1.50 4000
Jan-17 Oct-17 Jul-18 Apr-19 Jan-20 Oct-20 Jul-21
Source: UBS Asset Management, Bloomberg
It is our view that this provides a more challenging outlook for corporate credit than 2021. Spreads are more
likely to drift wider as markets demand some return of risk premium that had been compressed in the QE
era. However the relatively low duration and high quality of Australian credit should see it outperform other
markets such as the US.Contact us
Marcus Cleary Amanda Freeman Edward O'Neill
Head of Wholesale Client National Account Manager National Account Manager
Coverage Australia & NSW NSW / ACT
New Zealand (Maternity leave) T: 02 9324 3196
T: 03 9242 6510 T: 02 9324 3502 M: 0416 090 782
M: 0419 200 666 M: 0404 716 706
edward.o-neill@ubs.com
Marcus.cleary@ubs.com amanda.freeman@ubs.com
James Tomkins, OAM Luke Kliendienst Nathan Robertson National
National Account Manager Business Development Account Manager QLD
VIC / WA Manager, VIC/SA/TAS T: 07 3136 4466
T: 03 9242 6389 T: 02 9324 2195 M: 0420 425 054
M: 0449 852 637 M: 0431 897 659 nathan.robertson@ubs.com
james.tomkins@ubs.com luke.kliendienst@ubs.com
Alycia Vassallo
Consultant Relationship
Manager
(Maternity leave)
T: 02 9324 2248
M: 0417 230 387
alycia.vassallo@ubs.com
If you would like further information, please contact our Client Services Team:
Phone: 1800 572 018
Email: ubs@unitregistry.com.au
www.ubs.com/am-australia
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