How Rising Rates Could Affect Bond Portfolios

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Richard Lawrence

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Richard Lawrence, executive vice president in global fixed income at Brandywine Global Investment Management.

With central banks’ increased rates this year, the question is how does this impact bonds? What are the risks that we need to be thinking about? And also, what opportunities get created in this environment? I would say, right now, there’s clearly a perception in the market that central banks are behind the curve. We’re looking at safe haven bond markets in the U.S., Europe, Japan, et cetera, and they’re clearly not responding to geopolitical issues, the war in Eastern Europe, and seem to be responding exclusively to headline inflation pressure. As they do that, I think they’re probably ignoring, a little bit, the beginnings of a deterioration in the global growth backdrop. So it’s a pretty complicated environment right now.

In terms of how that impacts bonds, I think, near term, the story is all about inflation. But I suspect at some point, as the growth outlook deteriorates, and when I say that, what do I mean, well, leading indicators have started to soften up. I would say the PMIs, the purchasing manager indexes, are also probably going to start moving lower. When we look at statistics like the Federal Reserve in Atlanta has a GDPNow growth model, which suggests growth’s going to be pretty mediocre in the first half of the year. So it seems that right now the markets are ignoring that.

That’s actually created a lot of value in the bond markets. When we think about, for example, the U.S. 10-year bond model that we run, it’s flagging about two standard deviations cheap right now, so is our 30-year model, our European bond models are also flagging cheap as well. So at some point it’s quite possible, if we get enough of a deterioration in the growth outlook, that we will think about extending duration in developed bond markets.

In terms of opportunities for a fixed-income investor, right now, here we are in late March and our inclination is really to stay somewhat short, in duration terms, in developed bond markets. I think what could become a little bit more interesting as we move into the second half of the year would be opportunities in emerging markets. If we wind back to 2021, the emerging markets were raising rates earlier and fairly aggressively. And now we think it’s possible, here in 2022, that some of these emerging markets could reach the end of their hiking cycles, they’ll successfully bring inflation pressures under control, and I think that will provide an attractive entry point to extend duration in selective emerging markets.

When I think which markets, I’m thinking places, in particular, in Latin America. Markets like Brazil, Chile, Colombia. Frankly, Russia would’ve been another really interesting opportunity. The economics fundamentals, pre-war, in Russia, were looking really interesting for this trade, but obviously, given what’s happened in Eastern Europe, that’s the one that’s really no longer in the picture, in terms of an attractive investment opportunity.