Global Bonds: An Attractive Solution for Today’s Markets

Text on screen: John Valtwies, Account manager

Valtwies: Welcome to the first in a new series of updates with our global team. Sachin, can you walk us through your outlook for the global economy?

Text on screen: Sachin Gupta: Global Portfolio Manager and Head of the Global Desk

Gupta: Thanks, John. As we wrote in our cyclical outlook, we are now in a post-peak economy. That means both growth as well as inflation as we head into 2024 should be slowing down sequentially. Most of this has to do with the fact that we've now seen a lot of monetary policy tightening, which is in the pipeline. And over time, this is going to act as a drag on economies across the board.

Now, there's going to be some differences, as you know, across different economies. While we think it is probably a coin toss, whether or not the US slips into recession by the end of cyclical horizon, we think risks are probably higher across the rest of the world. A lot of it has to do with the fact that mortgage debt in many advanced economies is not only high, but it's also floating in nature. In other words, more sensitive to rate hikes.

We also believe inflation has peaked. We have already seen some significant evidence of that as both core and headline inflation have come off meaningfully from the highs we saw earlier this year. We see core inflation headed towards 2.5% to 3% zone in most of the economies by the end of 2024. So pretty close to central bank targets, even though not exactly there.  Lastly, history tells us that soft landings tend to be a rarity.   When you look at markets, whether bonds or equities or credit, we notice that markets are pricing perhaps immaculate disinflation. In other words, sort of a perfect landing. And we think that there is probably too much complacency in there.

Valtwies: Sachin, with that backdrop, when you're thinking about the global bond market, in your role as global portfolio manager, you invest across that $130 trillion global market across government bonds, corporate bonds, mortgages, to name a few.  With that lens, can you share with our investors what they can expect from interest rates?

Gupta: Sure. So first of all, we think developed market central banks across the vast majority of economies are very likely done with the rate hiking cycle. It is also quite likely that they keep rates at these high levels for an extended period of time. So they get more evidence of further cool down in labour markets, and some further progress on inflation side, towards their mandate consistent levels.

Volatility, we think, will stay on the high side in the short term as markets remain quite sensitive to small shifts in the economic data as well as messaging coming from the central banks out there.

However, when you take a step back and you take a look at the nominal and real yields in high quality bonds in developed markets, it's quite clear that these are very attractive levels. We haven't seen these levels since almost the global financial crisis. And the outlook for bonds looks pretty compelling.

On top of it, as we see more progress on the inflation side over the cyclical horizon, we believe that bond-equity correlation will go back to what we have been used to historically, whereby if equity markets falter, if risk assets falter, bonds will outperform and rally.

Valtwies: Well, with that backdrop of central banks having done all the heavy lifting. We look at starting yields of around 6% for bonds. How do we translate that to expectations for investors and when they're thinking about their bond allocation for the next 12 months?

Gupta: Big picture, vast majority of developed market central banks are pretty much done with the hiking cycle, even though policy rates may stay at elevated levels for some time.

Now, given the current level of yields, high quality bonds across countries already look pretty attractive to begin with, especially given our views on the trajectory of growth and inflation as we discussed previously, starting level of yields are pretty well correlated with subsequent returns.

And so as you said, given high quality bond funds are yielding somewhere between 5% to 6%, that looks very attractive on its own, but it also looks quite attractive when you compare with likely returns from the risk assets over the cyclical horizon, and especially given the growth is headed lower and there is risk of an economic slowdown all the way to possibly recession in many economies. 

Additionally, over the cyclical horizon as we see progress in inflation, heading towards central bank mandate levels, clearly the central banks will pivot from the current policy setting to rate cutting cycles. And as that happens, we think investors should be not only looking at returns from the bonds can do on the current levels, but also benefit from capital appreciation as yields go down.

Well, thanks, Sachin. And there you have it. The outlook for bonds is positive. We're likely to see interest rates remain elevated or at current levels for the next few quarters to come. But as we transition into that next phase, which could possibly include a recession, it's likely that the capital appreciation benefits of bonds will also come through, contributing to equity like return possibilities for bonds around the globe. To learn more, please get in touch with your PIMCO account manager. Have a great day.