Cross-Asset Quarterly Outlook

March 2023*

Fixed Income Returns Are ‘Sticky’ Despite Elevated Inflation

  • Fixed income marginally outperformed global equities over the quarter.
  • Valuations have improved for bonds, with the equity earnings yield spread to bond yields at the tightest level since 2010.
  • We upgraded Rates to neutral and downgraded REITs to neutral. Overall, the shift adds to our duration overweight. Commodities and Equities remain neutral.
  • Our asset allocation focuses on relative value opportunities intra-asset class.

Despite upside surprises to global activity and persistent inflation, fixed income marginally outperformed global equities over the quarter. This result may be surprising given that this growth/inflation mix is typically associated with stronger equity returns relative to bonds. However, Chart 1 highlights +0.4% returns for fixed income, while global equities produced a flat return over the quarter. This performance can be explained from yield levels and valuations.

Chart 2 shows that the earnings yield for US equities is now on par with the 6-month US Treasury bill and the US 10-yr Treasury bond yield. As investors allocated away from fixed income products, the spread between 10-year bonds and equities has become the tightest since 2010. The relative yield differential now favours bond allocations relative to equities. High-yield (HY) bonds are currently outperforming, reflecting a period of attractive yields and positive global growth surprises. However, we do not anticipate a strong growth reacceleration this year and prefer to position for activity deceleration as lagged monetary policy effects impact the US and European economies later this year. In this scenario, high-quality bonds should outperform.

“Sticky inflation and central bank tightening are often viewed as negative drivers for duration-sensitive assets such as bonds, REITs, and growth stocks. In the case of the US, a tight labour market and disruptions to the disinflationary trend pose risks that may keep bond volatility and yields elevated over the coming months. However, it is important to note that the current environment is a significant shift from 2022, when bonds experienced a sell-off due to rapidly surging headline and core inflation measures stemming from the Covid reopening, supply-chain readjustments, and commodity supply shocks. In addition, DM central banks were ‘behind the curve’ as they gradually shifted away from the transitory inflation narrative. Most DM central banks now have the highest policy rates since the Global Financial Crisis and are likely to reach their terminal rates by mid-year. While inflation may be ‘stickier’ than initially expected, the probability of another rapid inflation surge, that results in a surprise shock to bond investors, is much lower.

Chart 1: Asset Returns, Dec-Feb, %

Source: Bloomberg

Chart 2: US Earnings Yield, 6m Treasury Yield and US 10Y Treasury Yield

Source: Bloomberg

*The publication reflects asset performance up to February 28, 2023, and macro events and data releases up to March 8, 2023, unless indicated otherwise.

The information contained herein is obtained from sources believed by City of London Investment Management Company Limited to be accurate and reliable. No responsibility can be accepted under any circumstances for errors of fact or omission. Any forward looking statements or forecasts are based on assumptions and actual results may vary from any such statements or forecasts.