Fixed Income Framework: Cyclicality vs. Inflation

Hard landing? Soft landing? No landing? Stagflation? Much of the volatility over the past several months can be boiled down to the market repricing inflation and growth. On the equity side, we’ve helped a variety of clients align their portfolios with their market outlook through our cyclicality vs. inflation framework (Figure 1). This framework scores equity strategies based on exposures to industries that have shown a historical tendency to outperform in the four possible scenarios of growth and inflation coming in higher or lower than expected:

• Growth stays resilient, inflation comes under control (Soft landing)
• Growth stays resilient, inflation remains sticky (No landing)
• Growth slows, inflation comes under control (Hard landing)
• Growth slows, inflation remains sticky (Stagflation)

Investors with a market view can tilt their portfolio toward the quadrant that they view as most likely. Strategic long-term investors, or short-term investors without conviction in any market outcome, have used the framework to balance their exposure to the four quadrants, perhaps holding at least one strategy poised to outperform in each environment.

Figure 1 – Cyclicality vs. Inflation Framework: Equities

Source: Natixis Investment Managers Solutions

Applying the Framework to Fixed Income
This also has an interesting analog in fixed income. Resilient growth is good for credit spreads. Inflation coming under control is good for interest rates and duration exposure (Figure 2):

• Spreads compress, Treasury yields fall (Soft landing)
• Spreads compress, Treasury yields rise (No landing)
• Spreads expand, Treasury yields fall (Hard landing)
• Spreads expand, Treasury yields rise (Stagflation)

Figure 2 – Cyclicality vs. Inflation Framework: Fixed Income

Source: Natixis Investment Managers Solutions

Balanced Exposure to Four Scenarios
Which fixed income asset classes give balanced exposure to each of the four quadrants?

• In general, corporate bonds would outperform in soft landing, benefiting from the decline in both rates and spreads.
• Bank loans would do well in the no landing scenario, with the floating-rate profile protecting investors from rising rates, while prices likely increase from spread compression.
• Treasury bonds should do best in the hard landing scenario, in a risk-off flight to quality where rates rally.
• Treasury bills or money markets would hold up best in stagflation, when almost nothing else works.

Because the cyclicality vs. inflation framework is based on changes in expectations, the journey is just as important as the destination. Let’s see how each of these assets has performed so far this year, on a scale of 1 to 4. It’s been an environment favoring diversification, as each asset class has been a top returner for one month so far in 2023 (Figure 3). Over the entire period, the weakest performance has come from T-bills and the strongest from corporate bonds.

Figure 3 – Comparative Performance of Fixed Income Asset Classes – 1/1/23–4/30/23

Performance Rank (1 = Best)	Treasury Bills	Treasury Bonds	Corporate Bonds	Bank Loans
January 2023	4	3	1	2
February 2023	1	3	4	2
March 2023	3	1	2	4
April 2023	4	3	2	1
Year to date	4	3	1	2

Performance rankings based on the following indices: Bloomberg US Treasury Bills, Bloomberg US Treasury, Bloomberg US Corporate Investment Grade, S&P/LSTA Levered Loans 100.

What About Money Markets and T-Bills?
So far this year, many investors have happily sat in money market funds and earned an attractive short-term yield. But stagflation is the only environment of the four where being in T-bills or money market accounts is the best decision for your fixed income portfolio. According to the framework, putting all of your eggs in that basket is a bet that rates and spreads will both rise. No conviction would be having something in all four baskets.

Investors without much conviction on short-term market direction can hold a diversified basket of stocks with the ability to outperform in a variety of outcomes. Similarly, investors without much conviction on short-term market direction can hold a diversified basket of bonds with the ability to outperform in a variety of outcomes. The future is unknown and we would encourage positioning your portfolio for more than one scenario. If the majority of your fixed income allocation is still in T-bills or money market accounts, that means adding duration and potentially even adding some exposure to credit spreads. It’s the best way to hedge your bets.