US – Atlanta Fed wage growth tracker
The labour market will be crucial
If participation rates do not rise, the supply of labour will be insufficient to meet demand. This will trigger further increases in wages. If this is not accompanied by a parallel improvement in productivity, unit labour costs will increase. In that eventuality, central banks would have to respond much more forcefully than current market pricing reflects. This would be the key risk to our positive outlook.
A progressive withdrawal of monetary stimulus appears likely
Healthy economic activity and inflation that is well above central bank targets, in both developed and emerging economies, is creating a dynamic that is diametrically opposed to the one that has prevailed since the global financial crisis.
While monetary policy will tighten, we would argue that it is unlikely to stall growth. Policy will remain expansionary – just less so than it was in 2020-21.
Implications for bond markets
1: The macro environment we envisage should be supportive for credit spreads
Within the credit markets, high-yield is likely to perform better than investment-grade debt. It is less sensitive to higher rates and better able to withstand a period of elevated inflation. Robust growth, meanwhile, should ensure that defaults remain scarce.
2: Conditions seem likely to be challenging for government bonds
Interest-rate expectations in some economies now appear more reasonable than they once were. In the UK, for example, the market is now anticipating four-to-five rate hikes by the end of 2022. But the end point for interest rates implied in market pricing is, in our view, still too low. We think that long-dated tenors are particularly exposed to a removal of liquidity by central banks and an eventual end of QE.
The net supply of UK gilts is set to increase dramatically
3: We remain cautious on US Treasuries
We believe growth in the US economy has the potential to surprise to the upside in 2022. The labour market appears tight and inflationary pressures are broadening. So we are cautious on the US Treasury market, in both absolute and relative terms.
4: We retain a defensive approach in emerging markets
We have been short of emerging market bonds on several occasions over the past year. If our benign view of the path of economies proves wrong, emerging markets would be particularly vulnerable.
5: We are cautious on peripheral Eurozone bond markets
Economies such as Spain, Portugal or Greece would be very exposed to any removal of liquidity by the European Central Bank. Our short positions in peripheral European bond markets counterbalance our long positions in credit risk.
6: Valuations of inflation breakevens are too high in the UK
Ten-year inflation breakevens are trading close to 4 per cent, pricing in a very persistent overshoot of inflation relative to the Bank of England’s target. If inflation markets are correct, then nominal yields, especially in long tenors are too low. Therefore we are running short inflation positions relative to other jurisdictions such as Canada, where valuations are more reasonable, coupled with short positions in long gilts.
