No soft landing: Recession will come and bonds will benefit

Following the drastic and swift monetary tightening by developed market central banks, bond markets crashed and prices have been moving sideways ever since, says Charles Diebel, Head of Fixed Income Mediolanum International Funds.

What's next for monetary policy? Is a recession imminent for the industrialized countries? And what strategies are best for bond investors now?

Interest rate steps only have a delayed effect

Both the European Central Bank (ECB) as well as the Federal Reserve and the Bank of England have signalled in the past weeks that interest rate hikes are nearing their peak, and this is also in line with our own assessment. It is appropriate for central banks to pause for the time being and wait to see how economic data develops. Because from now on, everything depends on whether their measures are having an impact. 

The problem is that the effects of monetary tightening do not materialize immediately or everywhere at the same speed, with the result that economic data for different sectors are currently diverging. For example, higher financing costs have put a heavy damper on the manufacturing sector in particular - as shown by the Purchasing Managers' Index (PMI), which fell to 38.8 for Germany, for example, disappointing all expectations.

The employment rate and the service sector, on the other hand, are holding their own, prompting many an expert to be optimistic. This is due to the fact that private households are not yet feeling the increased interest rates as strongly. For one thing, sensitivity to interest rates has changed. An illustrative example are mortgage rates in the UK: Whereas twenty years ago these were linked to the central bank rate and rising interest rates immediately hit homeowners in the wallet, today more than 80 percent of mortgages have fixed interest rates for 2 to 5 years.

This means that a large proportion of consumers have not yet had to pay higher interest rates at all, even though the Bank of England has raised the key interest rates. To make matters more complicated, consumers saved up capital during the Corona pandemic - they are still spending it, thereby sustaining the economy.  

No soft landing: Recession is coming

Investors should not be fooled by the positive economic data. The full force of monetary tightening is yet to be felt - the effect is delayed, but it will come. Therefore, we do not argue that a recession has been averted and that we are instead seeing a "soft landing" - there has never been one in history before, as central bankers cannot calibrate monetary policy that precisely, especially with such drastic and rapid tightening as we are currently seeing. 

The more likely scenarios: Either the economy is more robust than expected and the tightening did not go far enough - in which case central banks will have to follow suit.

We experienced such a situation in the 1970s in the U.S., where the Fed stopped raising interest rates too soon, inflation heated up again and necessitated further, even more drastic, steps. Or - and this is the scenario we are expecting - central banks overdo it and trigger some kind of market event, as they did in the 1990s or in 2008, and eventually have to cut rates again or even introduce quantitative easing.

Precisely because interest rate hikes only have an effect after a long delay, we expect the central banks to have overdone it - and a full-blown recession to ensue. However, we do not expect this to happen before 2024. 

You have to be invested in bonds now

After the sell-off earlier this year, the bond market has been moving sideways for a while and there are still plenty of cheap entry points. However, it will take a while for the market to move from expecting more interest rate hikes to expecting stability and eventually to expecting rate cuts.

Moreover, for this to happen, economic data will first have to deteriorate significantly. Given that, fixed-income investments should hold up well. In our funds, we are neutral on corporate bonds at the moment and have increased duration only slightly - for now. The important thing now is to collect the carry. 

However, if we see weaker economic data - which we expect to happen in the coming months - then we will go all-in on duration. If the slowdown is significant, we will also reconsider our investments in corporate bonds, as spreads are likely to widen considerably. Once bond markets start to recover, investors with exposure to bonds can look forward to capital gains - but we are unlikely to see this scenario this year. However, for the coming year, we are confident.

By Charles Diebel, head of fixed income, Mediolanum International Funds