Bonds investors are grappling with the looming threat of stagflation. As recessionary risks accelerate, where can they seek refuge?
Regardless of where you turn, the spectre of the “S-word” – stagflation – looms. Driven by the US Federal Reserve (Fed), which has shown no sign of wavering in its commitment to tame inflation via hawkish rate hikes1, central banks worldwide have been forced to tighten or face importing inflation courtesy of currency depreciation.
Even as central banks tighten policy, snarled supply chains, the Russia-Ukraine war, and ongoing pandemic restrictions in China continue to feed inflationary pressures while weighing on growth. The World Bank expects global growth to hit 2.9% in 2022, compared to 5.7% in 2021 – reduced from an estimated 4.1% back in January 20222. This is leading to worries that many markets could enter a stagflationary period where the economy is contracting, yet inflation runs rampant.
Given such a possibility, it is worth exploring the implications of a stagflationary environment for global bond investors, beginning with a question.
The most important aspect of a stagflationary environment is rising yields as central banks raise interest rates to control inflation. Then, there are the added challenges posed by economic slowdown. This would increase default risk, particularly for lower-rated credits such as high-yield bonds. S&P recently predicted that the percentage of loss-making corporates globally could double to 17% by 2023 should interest rates and inflation continue to spike3. Such greater risks would inevitably be reflected in borrowing costs – driving yields up further.
In short, when it comes to its impact on bonds, stagflation is like inflation on steroids. However, we should caution against equating the current economic environment to, for instance, stagflationary episodes in the 1970s – they are substantially different. For one, the quantum of interest rate increases is tiny by comparison. Unemployment in the 70s was also at all-time highs4, in stark contrast to today’s tight labor market.
Although we may be a far cry from the 1970s, there is no doubt that stagflation is likely to have a negative impact on bond prices. And as the probability of stagflation continues to increase, the question for bond investors becomes –are there any havens?
We believe that one natural answer to this question is Asian local-currency government bonds. But before we delve into the reasons why, let us first look at why the US should be the last place for investors seeking to avoid the impact of stagflation.
With inflation remaining elevated, a recession would officially put the US into stagflation. And while the Fed is aiming for a so-called “soft landing” for the economy – whereby its rate hikes bring down inflation without triggering a recession – the odds are not in America’s favor.
Indeed, statistics show that out of the nine times the Fed has previously tried to bring down persistently high inflation – eight have resulted in a subsequent recession5. Based on that track record, that would be an 89% chance that the US is about to enter a slump, which would bring about at least a brief period of stagflation.
Contrast this to Asia, where economies and monetary conditions appear more resilient against the threat of stagflation.
Asia is by no means immune to stagflationary challenges. Yet, we assess such risks as significantly lower for two core reasons – lower inflation and recessionary buffers.
To begin with, inflation in Asia has been more measured compared to the West. Further, most of Asia’s central banks have already embarked on a tightening cycle to help ease such pressures. And while signs point toward inflation increasing in the near term, the odds of falling into a recession are still relatively low.
A recent economic survey showed that most economists put Asia’s chances retreating into recession at 25% or below6. When we dissect the data, it looks even more encouraging. Only South Korea is at 25%, while for China it’s 20%, Malaysia 13%, Thailand 10%, the Philippines 8%, and Indonesia 3%. Southeast Asian economies appear particularly resilient on the back of recovering tourism numbers and exports7, coupled with smaller interest rate increases.
As a final note, beyond the lower risks of stagflation for Asian economies, yields for most Asian local-currency government bonds appear to be peaking. For many markets, yields have already exceeded those seen in the Fed’s last hiking cycle back in 20188. This implies a decent possibility of a rally in these bonds as we move further into the second half of 2022.
While Asia may be the best chance for bond investors seeking refuge from stagflation, they should be wary of chasing yield at all costs. For instance, Asia’s high-yield bond sector is still feeling the after effects of China’s property-debt crisis9. In these uncertain times, sticking to more familiar issuance may be the way forward.
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