Adam Hetts: Welcome to Global Perspectives. We’re joined once again by John Pattullo and Jenna Barnard. John and Jenna are Co-heads of Global Bonds here at Janus Henderson. With this being the last episode of the year, it’s a great time to look forward into what bond markets might look like in 2023.

John and Jenna, thanks for joining. John, we’ll start with you. Can you go ahead and recap the global growth deceleration that’s been in place this year and your team’s general view of the macro world right now?

John Pattullo: Yeah, well, our view is that it’s very much that Boom-and-Bust economics is back. Really, as a legacy of the COVID response, whereby, unusually, you had a massive, almost warlike, fiscal and monetary response to get us out of lockdown and get going again. The rather depressing fact, I suppose, in hindsight, was they completely overcooked the chicken. That led to a massive boom. Even if you were sympathetic to MMT (Modern Monetary Theory) and fiscal expansions, this has been an abject failure. The MMT school would say, “Well, you print money, and you expand fiscal policy to close unemployment, then you stop.” You don’t keep going.

Broadly speaking, a lot of that stimulus was consumed. It wasn’t invested in healthcare, technology, infrastructure, building schools, hospitals, and all of that sort of stuff. It was broadly spent. The goods sector couldn’t cope with that. That was, then, obviously compounded by the Ukraine war and all of the bottleneck problems that we’ve had. That led to a massive inflationary surge, which then led to a massive and very aggressive response by the Fed who were late to the party, behind the curve, arguably got a bit muddled on the tightness of the US unemployment market. As I said, the Ukraine war and various other factors put the brakes on very hard, then we were screeching down the other side.

Very briefly, if we were looking for a recession, we’d look for the following things. You’d look for a strong dollar, super-high energy price, a shrinkage in the rate of change of money supply growth, and an inverted yield curve. And guess what? We have all four.

Hetts: You’re saying, “Boom-and-Bust.” You’re talking about wartime-like stimulus. There’s also a lot of talk about this part of the cycle of being a little more fundamental, not bust as in a crisis sense, but that we’re getting into a bit of this global slowdown and potential earning weakness or earning recession on the equity front, and a little more of a typical cycle to weather through. Do you feel that it’s not so typical, actually?

Pattullo: No, I’d say that it’s more typical. It’s more like when I was young. It was almost a political business cycle. Whereby, you stimulate the economy to get us out of COVID or to get re-elected. The sine wave, if you like, is quite short and quite pronounced. That’s actually, Adam, I think, easier to comprehend and understand. It should actually provide investors and asset allocators greater opportunity because I think the various asset classes will move faster.

Hetts: It’s a little bit more of a straightforward playbook. Jenna, where do things go from here, as far as that playbook? What type of leading indicators are you focused on for the next step of the cycle?

Jenna Barnard: Very long lead indicators, 6-12 months, anticipatory indicators, housing cycles, monetary aggregates, yield curves, that John has referenced. Everything has completely collapsed, a synchronized collapse. The speed and depth of the downturn of those long lead indicators, we haven’t seen anything like it since the early-1980s. It’s in every country that we look at.

Objectively, there are no signs of a bounce in those indicators. It suggests that the first half of 2023 is going to be very difficult from a growth perspective.

Traditional lead indicators, like the Conference Board, that’s already well and truly into recession territory. Coincident indicators, like industrial production, employment, which we’ll come to, are just turning, turning as we speak. Really, it’s the exciting phase of the growth downturn for bonds. We’re getting into the depths of it. As I said, the first half of 2023 is going to feel, I think, pretty shocking from a growth perspective.

Where does the opportunity come from? The opportunity comes from bonds having completely decoupled from growth momentum, completely decoupled.

If you managed bond funds, going back to the early-1980s, you get long duration as growth momentum peaks, and bond yields roll over in real time with that growth momentum. The growth momentum has been completely collapsing. Here, we’re using a six-month rate of change for ISM new orders, completely collapsing, and bond yields have gone vertical. That happened three times from the early ‘70s to the early ‘80s. On three occasions you have that decoupling. It does not go on forever. The opportunity is that eventually it gets too stretched, and bond yields reconverge down to the growth momentum. We are just at that point. That’s why it’s so exciting for bonds.

What does it take for that recoupling? Peak inflation, and we can talk to you about that. The first half of next year is the collapse in CPI inflation. A collapse. That’s going to be the heart of the move. The core CPI is a more linear process throughout the year. For headline CPI, it’s going to be very fast into June. I think that inflation swaps have fixings of around 2.3 for June. That’s the first point.

The second, the turn in employment, we can talk to you about that, as well. That was a key catalyst required for bond yields to recouple down to growth momentum in the ‘70s. Everything that we look at suggests that that is coming as well in Q1 of next year (2023). The bond market is already picking up on that. The bond markets are no longer responding to Powell’s hawkish talk on the hawkish dot plot. They are well and truly moving on. As I said, we are coming into a really opportune time, it’s the only asset class that hasn’t repriced with that growth momentum. When it happens, it can be very fast and furious.

That’s really where the opportunity comes from. The lead indicators haven’t changed for months. They all look very depressing. It’s just how far could you stretch bond yields away from that negative growth momentum? In October, if you look at it on a Z-score basis, we were as decoupled from growth momentum as we were in 1980 and 1966. Those are the only comparable periods. Yeah, we’re basically excited about bond total returns, both the income and the capital, as we move into next year.

Hetts: I see why you’re getting excited. The first point, then, about that decoupling, in a simple sense, is that the growth momentum is already rolling over, but the bond yields haven’t yet rallied with the growth slowdown. And so, is that essentially because of the inflation variable?

Barnard: Yes, yes, yes.

Hetts: Is that what this has in common with those three times since the ‘70s?

Barnard: Totally, yeah, totally, core CPI shock, not headline but core CPI shock, and an aggressive response from central banks. Remember, this rise in bond yields this year has been all about the real yield. It’s not about the bond market’s inflation expectations, that has actually declined over the course of the year. It’s all about central banks responding late, hiking into the wrong phase of the cycle, and driving real yields higher. Frankly, we’re reaching the limits of that, so yeah, that’s exactly right, Adam.

Hetts: As far as those limits, is it reasonable to compare to those historical scenarios since the 1970s? How long can the decoupling persist? Is it historically a matter of months or quarters, or is it years sometimes?

Barnard: No, not years. It persists, when we’ve looked at it, until, in two of the three occasions, the first negative nonfarm payrolls print, in real time. unrevised. Another example took a little bit longer, until, I think, slightly more lagging indicators turned. But no, it doesn’t persist for years. It’s a matter of quarters at most. We have two pieces of the puzzle that have got to fall in place to get that recoupling, one is peak inflation, which, in the US, is very convincing at this point. The second is really the employment market turn. I can talk to you about that if you’re interested.

Hetts: Please, yes, that was the next question. Employment and its importance, let’s dig into that.

Barnard: Yeah, the employment market, when we look at it, frankly, in summary, nonfarm payroll looks very much like the outlier. It has artificial strength relative to the Household Survey. 80% of the time, the Household Survey, which feeds the unemployment rate, and the Establishment Survey, which feeds the nonfarm payrolls, move together. When they don’t, the Household Survey leads nonfarm payrolls 75% of the time. The tax data, withholding tax data, as well, that we use, has shown a very sharp slowdown in aggregate wage income, which supports the Household Survey.

Things like JOLTS, this inflection point down in job openings, that happened when you got the first negative nonfarm payroll back in the ’07 cycle. The inflection in JOLTS is actually quite a coincident indicator. It’s not a leading indicator. Obviously, things like Challenger Job Cuts and so forth, so I think if you’re optimistic, you’ll say that the labor market is much better balanced now. Lead indicators, like hours worked, the type of employment indicators that feed into the Conference Board lead indicator are already signaling recession or collapse back down. When we model out business cycles using economic models but looking at business cycles in the lead-lag, very much Q1 of next year should show a sharp slowing in employment growth in the US. If anything, a risk for a negative nonfarm payrolls.

In other developed markets that we look at, we’re starting to see turns in the unemployment rate but very gradually. If anything, it’s bottoming and starting to turn. There, you have very different wage dynamics by countries. So places like Europe and Australia have very limited wage growth. In the UK and US, obviously much higher wage growth. So yes, Q1 of next year is potentially setting up for this collapse. The heart of the collapse in the headline CPI and a much more convincing weakening in employment markets, as well, based on normal business cycle leads.

Hetts: So if we’re facing that recoupling going into early next year, obviously [that is] positive for duration risk. We, also, have an inverted yield curve, at least in the US. What do you think that this means for fixed-income investors? How about navigating that short or intermediate – and I know that you’re a Global Bonds team – what does it mean geographically for you?

Pattullo: I can take that. Firstly, bonds are competitive within themselves against history. You have, in any historical context, bond yields that are pretty good. Real yields are positive, Adam, which is unusual. Thirdly, you’ve had a widening, obviously, sovereign yields have risen, as prices have gone down. Corporate bonds spreads have widened, as prices have gone down, so you’ve had that double-negative. The absolute yield that you can see in corporate bonds, we think, is really appealing. It’s also with bonds, that those yields are very competitive against other asset classes. Currently, they’re competing for cash for obvious reasons. But when cash rates peak and come down, you have to anticipate people pushing longer, for short-term bonds and intermediate bonds, obviously, but you have to imagine that that will come as the next part of the cycle. That, I think, is really interesting, as well. Going forward, that is the cycle. That’s how it’s meant to work. That’s why we think that bonds are appealing from here.

As I said, they really compete with equities, as well. That’s how the cycle rebuilds itself. Then, of course, the curve starts dis-inverting or steepening up as front ends eventually come down. Then, you will want to push longer. One thing that we have been conscious of is the credit curve, as in the extra spread that you get over the sovereign curve, is actually quite flat. You don’t want to push too long along the curve in credit.

Hetts: Are you looking at investment-grade credit or do you see a role in non-investment-grade at this point?

Pattullo: Yeah, again, investment-grade has to compete with high yield and other asset classes. Investment-grade tends to correlate pretty well with rates volatility and correlates very well with sovereign bonds, so they tend to move in the same direction. High yield is more of a risk-asset class. Subject to your view on the downturn, at its simplest, in a soft landing, you would venture into high yield. But why bother because high yield spreads today are roughly 440 [basis points]? The high yield market is saying that there’s a soft landing coming, it’s all happy as Larry. We don’t feel that that’s a good risk return at present because if you actually buy the hard-landing recessionary case, high yield spreads could easily be 700-800 [basis points] over.
Hetts: Okay, and it’s December 15th, right now, by the way, for listeners. You mentioned around 440-ish on high yield spreads. To your point, in the hard landing scenario with that type of spread widening, those yields aren’t enough cushion to outperform the investment grade counterparts is your point.Pattullo: Correct, in a hard-ish landing scenario, yeah.

Hetts: Okay, thanks. And I’m just realizing, being here in Denver, I’ve been a bit biased in this conversation. I’m thinking about the US yield curve and US spreads. You two are over in London. From a global perspective, are you being somewhat US-focused in the opportunity set right now? What is the global opportunity set and the global mix looking like?

Barnard: There’s not a huge geographic dispersion between European and US high yields. Really, the peak systemic risk for Europe, was in October, when you had the gilt crisis in the UK and you had maximum fears about energy during the winter in Europe. But then we had a period of very warm weather. The general feeling is that that energy crisis, at worst, has been kicked off until next winter. There’s a little bit of extra spread in Europe but I wouldn’t say that it’s really any huge differential opportunity set there to be mining. Once you get beyond Euro-denominated credit, you’re really talking very small, relatively illiquid backwaters, which are much trickier to trade tactically. So no, Adam, there’s not a massive geographic opportunity set in credit.

Remember, quality issuers, big issuers in investment-grade, they’ll issue in every currency. It’s not like you can only buy a US company in the US dollar credit market. It’s a bit different from equity investing from that perspective. So if there is an opportunity set, thinking about geographies, it’s much more in the interest-rate divergence. Which central banks are actually going to turn dovish quicker? There was the Reserve Bank of Australia. The governor there was actually quite critical of Powell. They said they weren’t going to follow a scorched-Earth policy of getting inflation down as quickly as possible. They’d rather actually take a bit longer and protect the employment market. You get slightly more dovish tones in certain geographies. Obviously, the Bank of England is always weighing the high inflation against the growth risks. The European Central Bank (ECB), you have an ultra-hawkish ECB. I think, the geographic opportunities are much more in the interest-rate space and the potential divergence in policy there than it is in credit.

Pattullo: I think the Fed is arguably a bit further down the line. It’s probably a bit cleaner and clearer to see the outlook in the states. As Jenna has said, the ECB has come out today (15 December) as remarkably hawkish in trying to defeat broadly supply-side inflation, which is broadly the high, but now, falling oil price, so that’s put a bit of a spanner in the works. Sometimes, these central banks are a little hard to read. Whereas, of course, last night, we had the Fed. The market wasn’t particularly interested in what the Fed had to say, because the dollar and the weak oil price is already sniffing a turn in the cycle in the States, and that gives us a lot of corroborative evidence that we’re making sense here. The dollar had one of the weakest Novembers, I think, for a decade, which would suggest, arguably, the interest rate differentials are falling against the dollar. As I said, the oil price is down on the year now, which would suggest that the demand destruction that the central banks are putting through is working; hence, the cycle is turning over in the camp that we’re in.

Hetts: Okay, so this has been a great summary as we are going from decoupling to recoupling between rates and the growth environment. So Jenna, can you just sum up in total what this means for bond investors right now or at least what it should mean.

Barnard: In essence, we think that the outlook for bonds is a once-in-a-cycle opportunity. We have yields, which are back to the early-2000s. The yields on core fixed income, government bonds, quality investment-grade bonds have materially repriced to levels that we haven’t seen since 2008 or before. You don’t have to stretch for yield. There’s opportunity, given where we are in the cycle and given how stretched bond yields are, relative to growth momentum, as the inflation cycle is turning, and it’s turning fast. Frankly, 60/40 was dead this year. It could be ripping next year. Bonds could well do exactly what they’re supposed to do in portfolios. They didn’t do it in 2022 for completely rational and logical reasons related to inflation and central-bank response. 2023 looks like a completely different environment.

Hetts: Well, that definitely helps sum it up. So we have a lot of pessimism on the economy but a lot of optimism on core bonds. So, thanks John and Jenna for the recap here. And thanks listeners for joining. If you like this, check out more Global Perspectives wherever you listen to your podcasts and also the Janus Henderson Insights website for more views from all of our investment teams. See you next time.