International Bond Markets Brace for Challenges Amidst Rising Yields and Policy Crossroads

Global bond markets are experiencing heightened volatility as yields surge once again this year, driven primarily by developments in the United States, which often sets the tone for international markets. The recent sustained increases in key official interest rates have led market participants to speculate that the current interest rate cycle might be approaching its peak. While some central banks have hit the pause button on rate hikes, they are keeping a watchful eye and maintaining the option for further increases if needed.

The International Monetary Fund (IMF) has issued a timely warning based on a recent paper that examined 100 inflation-shock episodes across 56 countries since the 1970s. The study reveals that bringing inflation back down is a challenging task, with success achieved in only 60 percent of cases within a five-year period. Premature celebrations, where inflation initially declines only to plateau or re-accelerate, were common pitfalls.

One key takeaway from the IMF study is that successful disinflation requires tighter monetary policies, lower nominal wage growth, and fewer currency depreciations. Countries that effectively reduced inflation experienced short-term output losses but avoided major declines in output, employment, and real wages over a five-year horizon, emphasising the importance of policy credibility and macroeconomic stability.

While acknowledging these historical lessons, central banks are expected to maintain tight monetary policies in the face of sticky inflation rates. This stance is likely to restrict economic activity and keep growth rates low, prompting investors to prepare for an extended period of elevated inflation and interest rates. The normalisation of yield curves is anticipated to be slow and gradual, with the slowing pace of policy rate increases not signalling a return to pre-crisis normalcy.

In the United States, a significant economic downturn is deemed unlikely due to robust private consumption and a strong labour market, paving the way for a substantial recovery by the second quarter of next year. However, the Federal Reserve remains vigilant about a potential wage-price spiral, maintaining a hawkish stance despite cutting key interest rates. In the eurozone, stubborn core inflation is expected to deter significant easing of the European Central Bank's monetary policy.

As for emerging markets, bond markets are projected to trade near current levels over the next 12 months, with potential improvements in sentiment regarding China's real estate sector redirecting focus to the strong micro-fundamentals of emerging-market corporate bonds. However, EM sovereign bonds may face headwinds from country-specific fiscal risks and lower economic growth in China.

When it comes to equity markets, big-tech companies that benefited from the artificial intelligence boom drove the S&P 500's performance in the first half of 2023. While valuations remain stretched, the STOXX Europe 600 is expected to offer attractive upside potential, especially if the Chinese economic recovery regains momentum. Japan's TOPIX, after a marked rise early in 2023, could see gains resume with a pickup in nominal GDP growth and strengthened corporate governance.

Commodity markets are witnessing oil prices rise due to production cuts, declining Russian oil exports, and geopolitical events in the Middle East. Despite worries about economic growth, there is a slight expectation that gold prices will increase by the end of the forecast period due to the possibility of a recession and anticipated future interest rate cuts.

In the real estate sector, higher interest rates and rising construction costs are straining the market, but most countries and segments are coping well due to solid fundamentals. The office segment is experiencing a downward trend, while premium office properties meeting high environmental standards continue to enjoy robust demand and rental growth.

Amidst these challenges, investment managers are advised to adopt subtle shifts rather than dramatic changes in strategy. Bond yields are expected to remain elevated, and corporate fundamentals should stay solid. Stock markets are likely to weather downturns well, particularly with increased corporate profits in the technology and communications services sectors.

As investors navigate these uncertainties, a measured investment approach that combines long-term investments with sound risk management is recommended. Looking beyond immediate monetary-policy developments, the focus should extend to profound real-world changes, analysing investment implications through long-term themes such as next-stage technology, resource transition, and population support.