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Navigating Inflation in 2022: Is Fixed Income Oversold?

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The last two years have been exceptionally difficult for fixed income investors; declining bond prices due to rising yields continue to punish them with substantial losses, relative to their yield. Could this turbulence in fixed income be an opportunity though?

Fiera Capital’s Integrated Fixed Income (IFI) team oversees more than $30 billion in fixed income assets. They believe there are some very compelling fixed income opportunities that Canadian investors should consider through 2022. Below, we provide the Fiera team’s outlook on fixed income and an overview of key strategies that investors could consider to potentially improve their risk-adjusted returns for the remainder of this year.

Fiera Capital’s view on fixed income asset classes for 2022

In general, Fiera Capital’s IFI team continues to see opportunities in the credit space to both enhance yield and target added-value opportunities. Additionally, the higher yield provided by corporate bonds over government bonds can help cushion the impacts of rising rates on fixed income portfolios and improve outcomes versus traditional strategies.

Fundamentals for corporates remain solid with economic growth for both the U.S. and Canada. The IFI team believe there are now lower odds of further negative impacts in 2022 from the pandemic, and future growth remains well supported by high savings rates among Canadians and the continued reopening of the economy.

Even though risk asset volatility has increased since the start of the year, the IFI team only expects a modest widening, which could provide ample opportunity to add value to their portfolios. Since the start of the year, valuations appear to have become more attractive and there is ample opportunity to benefit from this adjustment in both the primary and secondary fixed income markets.

Market backdrop: IFI base case

The IFI team’s base case scenario forecasts economic growth will be in the 3.5-4% range in 2022 for both the U.S. and Canada. The COVID-19 Omicron variant could bring some short periods of negative impact on growth in Q1 2022, but they predict the remainder of the year should be solid.

They believe inflation should also gradually decrease towards central banks’ tolerable levels following the progressive rate hikes, but it will take some time. The IFI team expects the Consumer Price Index (CPI) to remain around 3.25% by year-end for Canada and in the 3.5-4% range for the U.S.

In light of the elevated level of inflation, they assume that central banks might be less responsive to market volatility – particularly within equity markets – and that central bank tolerance for an equity market sell-off might be higher than in previous cycles.

Generally, central banks have turned more hawkish. For example, the Bank of Canada (BoC) ended quantitative easing in 2021 and the U.S. Federal Reserve (the Fed) is expected to end it in Q1 2022. The IFI team expects four hikes by the BoC and the Fed in 2022, and consequently, the IFI team forecasts the 10-year and 30-year rates to rise towards 2.10% and 2.25%, respectively, by the end of the year. They also expect that both the Fed and the BoC will stop hiking rates in 2023 and will not have to go above 1.75% in this rate hiking cycle – their base case for terminal rate. Given the backdrop, the IFI team expects credit spread volatility and rates to remain elevated during this transition to tighter monetary conditions in North America.

Preferred Shares – Overweight

Preferred shares continue to offer potential upside with compelling opportunities in the fixed reset space. Although the IFI team does not expect growth to be as high as it was in 2021, they believe a total return between 4% and 6% is achievable with most of it coming from dividends (current yield close to 4%) and some capital gains (around 2%). This represents an attractive performance potential in what is still a low-rate environment.

The BoC is expected to hike interest rates multiple times this year, which could push the 5-year rate higher and continue to be a net positive for Canadian preferred shares. Issuers will likely continue to redeem expensive preferred shares and replace them with a mix of hybrids and Limited Recourse Capital Notes (LRCNs). The IFI team expects a total of $8.5 billion of redemption in 2022, or 13.1% of the market. They expect more volatility in 2022 in both interest rates and credit spreads while retail investors could decide to take profit, which could exacerbate volatility.

Emerging Markets Debt – Overweight

Credit spreads of emerging markets debt are currently comparable to high-yield spreads. The current environment is supportive of commodities and that should provide a strong backdrop for some emerging market countries.

Central banks in emerging market countries have already hiked rates as they are considering inflation as the key risk to their economies. As such, the team sees opportunities emerge in certain areas of the curve for some of these emerging market countries.

Emerging markets’ yield carry compared to that of developed economies remains attractive and continues to provide an attractive risk-reward proposition.

Corporate Bonds – Overweight

The IFI team continues to see opportunities in the credit space to both enhance yield and find added-value opportunities. Additionally, the higher yield provided by corporate bonds over government bonds helps cushion the impacts of rising rates on fixed income portfolios and improve outcomes versus traditional strategies. Fundamentals for corporates remain solid with economic growth and the base case is in the 3.5-4% range in 2022 for both the U.S. and Canada.

Universe Bonds – Underweight

The IFI team expects interest rate volatility to remain elevated as central banks reduce support and growth decelerates. They also expect growth to remain above potential in 2022 and peak inflation to occur in the first half of the year before decelerating. For inflation, they believe it will remain above the BoC and Fed’s 2% inflation target, which will support rate hikes over the course of the year to gradually lessen demand. The IFI team is favouring defensive, stable sectors with strong liquidity and which they believe will have positive momentum. This includes provincial, municipal and financial sectors, as well as moving up in credit quality.

Conclusion

The IFI team believes an actively managed Canadian universe bond strategy can still help investors navigate through a market environment that is likely to experience bouts of elevated volatility. Bonds are a core holding for investor portfolios for good reason, providing stable income, diversification and capital protection benefits – although the past 12-months have certainly tested the resolve of investors as the shift from ultra-accommodation to financial tightening unfolds. It is important to keep in mind the vital role bonds play. Retaining duration in a portfolio has proven time and time again as an effective hedge during periods of market stress. An active approach and well-thought allocation to bonds should continue to provide diversification benefits and act as an effective ballast in multi-asset portfolios.

The views/opinions expressed herein may not necessarily be the views of Horizons ETFs Management (Canada) Inc. All comments, opinions and views expressed are of a general nature and should not be considered as advice to purchase or to sell mentioned securities. Before making any investment decision, please consult your investment advisor or advisors.

Certain statements may constitute a forward-looking statement, including those identified by the expression “expect” and similar expressions (including grammatical variations thereof). The forward-looking statements are not historical facts but reflect the author’s current expectations regarding future results or events. These forward-looking statements are subject to a number of risks and uncertainties that could cause actual results or events to differ materially from current expectations. These and other factors should be considered carefully and readers should not place undue reliance on such forward looking statements. These forward-looking statements are made as of the date hereof and the authors do not undertake to update any forward-looking statement that is contained herein, whether as a result of new information, future events or otherwise, unless required by applicable law.

This document is intended only to provide general information and is not intended to be and should not be construed or relied upon as legal or other professional advice. Fiera Capital Corporation assumes no liability by providing this guidance to its clients or any other person or entity. The information provided herein may or may not apply in any particular situation. Users should carefully review the guidance included here to determine applicability. The information and opinions herein are provided for informational purposes only and are subject to change. The information provided herein does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. Views expressed regarding a particular company, security, industry or market sector should not be considered an indication of trading intent of any funds managed by Fiera Capital Corporation.

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