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Customers queue outside the Bank of Spain to purchase short-dated debt, known as letras, in Madrid on February 3. Every recent weekday morning at dawn, a queue has formed outside Spain’s central bank as savers from across the city come to get their hands on something unheard of for more than a decade: a return of nearly 3 per cent. Photo: Bloomberg
Opinion
Macroscope
by Chris Iggo
Macroscope
by Chris Iggo

High interest rates and slow earnings growth make bonds attractive to investors

  • Bond markets appear aligned with the consistent messages of higher inflation rates and slowing corporate earnings, with corporate bonds delivering good yields
  • Equity markets remain volatile, even though the long-term outlook is positive
Chris Iggo
Chris Iggo
Why you can trust SCMP

Financial markets continue to reflect two important themes. The first is that interest rates are going to remain significantly higher than the average of recent years until there is unequivocal evidence that inflation is returning to a more comfortable level. The second is that corporate earnings growth is slowing.

The question for investors is whether current market pricing has fully incorporated those two trends. My view is that bond markets are aligned with the messages coming from central bankers and therefore offer some attractive opportunities for investors.

However, equity markets remain subject to the risk that more bad news might be coming. This means returns from equity markets could be quite volatile in coming months, even if the long-term outlook remains positive for equity investors.

Officials from central banks have continued to warn that current inflation levels are too high and monetary policy might need to be tightened further to bring down inflation. Until recently, markets had not quite got the message and were encouraged by lower headline annual rates of inflation.

In the United States, the headline year-on-year rate of consumer price inflation peaked at 9 per cent last June and fell to a 6.4 per cent pace in January. In the European Union, inflation peaked later at 10.6 per cent in October but has also come down since then to 8.5 per cent in January.

Economists generally see inflation falling further in coming months as lower global energy prices, reduced pressure on supply chains and base effects combine.

A hiring sign is posted inside a discount department retail store in Las Vegas, Nevada in May last year. US labour markets remain very tight. Photo: AFP

Despite this encouraging trend, there is evidence that inflation is sticky. Inflation in the services sector is not falling as quickly while, importantly, labour markets remain very tight. The US economy generated 517,000 new payroll positions in January, and the unemployment rate in both the US and Europe is at its lowest for decades.

The risk here is that higher wage growth will result, adding to core inflation pressures. Central banks such as the US Federal Reserve and the European Central Bank want to raise rates a little more and keep them elevated. The market has adjusted its pricing to reflect that. No cuts in interest rates are expected in 2023.

Higher interest rates are reflected in yields in global bond markets. This makes fixed income an attractive asset class given the economic outlook. Government bond yield curves are inverted – meaning yields on longer-dated bonds are lower than those on short-term bonds – but in the corporate bond market this is not the case.

In the US, for example, yields on investment-grade corporate debt are roughly the same across all maturities, between 5.25 per cent and 5.5 per cent. For investors who have been frustrated by low yields for years, the market is now much more rewarding.

Tighter monetary policy does bring the risk of slower economic growth and a more difficult environment for companies. Central banks want to slow aggregate demand to help deliver lower inflation. That means a risk of recession. Very often there is a considerable lag between tighter policies and growth slowing down.
US Federal Reserve Chair Jerome Powell speaks during a news conference at the Federal Reserve Building in Washington on February 1. Powell has said cuts in US interest rates are unlikely in 2023. Photo: Reuters

For the corporate bond market – where returns are in part determined by the ability of corporate borrowers to generate sufficient cash flow to meet interest and maturity payments – there is a chance of some deterioration in the business environment. However, most borrowers have been able to build robust balance sheets in recent years. Even in the riskier high-yield bond market, the consensus view is that default rates will remain low.

For equity markets, the risk is more tangible. Corporate earnings growth has slowed, and analysts expect a further slowing in earnings growth this year.

Some might argue this is already reflected in the poor performance of global stock markets in 2022. Markets are trading on valuation levels that are significantly lower than the heady days of the recovery from the Covid-19 pandemic, but a tighter monetary environment for longer does generate the risk of a resumption of last year’s bear market, especially given how much markets have surged in recent months.
The US equity market has a particular problem. The aggregate level of corporate earnings is still well above its long-term trend. It was boosted by abnormally high profits made by technology companies in the pandemic and by the profits earned by energy companies since the Russian invasion of Ukraine.

The adjustment is already taking place in the technology sector, with many companies announcing weaker earnings and taking steps to reduce costs. In time, lower energy prices will also weigh on the profits of energy companies.

Both these trends could reduce the aggregate level of earnings per share in markets such as the S&P 500. Theoretically, a return to trend earnings for the US stock market and to average valuation levels – a long-term price-to-earnings ratio of 16.5 times earnings rather than the current 17.8 times – would mean a price level significantly below current levels.

The new monetary environment poses challenges for investors. In the short term, there are risks to global equity markets. However, at current valuations, the prospects for long-term positive returns are good.

Meanwhile, bond markets offer attractive returns right now given the level of yields and the outlook for lower inflation and a peak in interest rates in the months ahead.

Chris Iggo is chair of AXA Investment Managers Investment Institute and chief investment officer of AXA IM Core

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