Morgan Stanley IM: 2022: Good-Bye, Farewell, Amen!

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Optimism based on declining inflation, weaker growth, and less hawkish central banks proved to be illusory. The Fed, European Central Bank and Bank of England all raised rates 50 basis points (bps). The ECB emphasized they were far from done, with their multi-year inflation forecast still above target. The Fed appeared to backtrack a bit on their November comments about wanting to wait and see how previous tightening was impacting the economy before committing to additional rate hikes. The change of tone was noticeable. Not surprisingly, European bonds were hit particularly hard, with French 10-year yields up over 70 bps on the month and Germany not far behind. U.S. Treasuries did reasonably well, with 10-year yields up only 27 bps. Credit markets bucked the trend a bit with U.S. investment grade and European credit markets marginally tighter on the month. U.S. high yield was the outlier, with spreads over 20 bps wider on main indexes. Securitized markets also did well in spread terms, as they continued to play catch up to the corporate credit markets. Equities, after staging an impressive rally over late summer and early fall, also did terribly, with the S&P 500 down almost 6% on the month.

Why did yields rise so significantly? Several factors were at work. First was continued hawkishness from central banks. It might have been wishful thinking more than fact-based analysis, but markets expected some softening in actions/rhetoric from the Fed and ECB. No such luck. Second was the surprising action by the Bank of Japan (BoJ) to adjust their yield curve control (YCC) policy. They increased the top end of the range on 10-year government bonds (JGBs) to 50 bps from 25 bps. While not such a large move in absolute terms, it was earth shattering given prevailing expectations. The move hinted at more adjustments to come in 2023, both in terms of yield curve targets as well as conventional monetary policy. This change improves the attractiveness of Japanese government bonds to domestic investors, who may decide to allocate less to offshore markets. This worry, in addition to the worry that another major central bank was about to embark on a tightening path of an unknown amount, boosted anxiety and volatility.

If increased nervousness about central banks was not enough, other forces were also at work. China decided to abruptly drop their zero-Covid strategy and move immediately to a world with no Covid restrictions at all. While this was expected to happen in 2023, it was expected to be gradual. Although this may have some short-term negative impact on growth, it will also accelerate the reopening of the economy, boosting growth, domestically and abroad, and maybe slow down global disinflationary forces. Chinese equities took the policy change well, suggesting optimism about getting the economy back on track.

The actions in China and Japan had a particularly negative impact on Australian dollar bonds. The Australian central bank (RBA) had become one of the most dovish G10 central banks, supporting their bond market. But, the China reopening and revised BoJ policy sent shivers through the Australian bond market, causing Australian 10-year yields to rise over 50 bps, reversing their previously strong performance versus U.S. Treasuries.

Another notable development in December was the continued weakness in the U.S. dollar. A combination of valuation, increased hawkishness of other central banks (ECB, BoJ, in particular), and continued decent growth outside the U.S. boosted non-U.S. economies, hurting their bonds, but helping their currencies. We believe that a weaker dollar is an important indicator that the worst is past for the global economy, particularly for emerging markets.

There is some good news. Yields are higher than they were at the end of November (let alone the beginning of 2022), boosting 2023 expected returns, the U.S. dollar is no longer going up, and credit spreads are meaningfully wider than they were in early 2022. And, in a truly historic way, the stock of negative yielding bonds has gone to zero for the first time since 2014! A notable achievement, putting income back into fixed income, which can help provide a greater cushion for unexpected negative surprises. It only took a record setting sell-off and the worst returns in over 100 years to do it. May negative yields rest in peace.

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<sup>RISK CONSIDERATIONS

Diversification neither assures a profit nor guarantees against loss in a declining market.

There is no assurance that a portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the portfolio will decline and that the value of portfolio shares may therefore be less than what you paid for them. Market values can change daily due to economic and other events (e.g. natural disasters, health crises, terrorism, conflicts and social unrest) that affect markets, countries, companies or governments. It is difficult to predict the timing, duration, and potential adverse effects (e.g. portfolio liquidity) of events. Accordingly, you can lose money investing in a portfolio. Fixed-income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In a rising interest-rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. In a declining interest-rate environment, the portfolio may generate less income. Longer-term securities may be more sensitive to interest rate changes. Certain U.S. government securities purchased by the strategy, such as those issued by Fannie Mae and Freddie Mac, are not backed by the full faith and credit of the U.S. It is possible that these issuers will not have the funds to meet their payment obligations in the future. Public bank loans are subject to liquidity risk and the credit risks of lower-rated securities. High-yield securities (junk bonds) are lower-rated securities that may have a higher degree of credit and liquidity risk. Sovereign debt securities are subject to default risk. Mortgage- and asset-backed securities are sensitive to early prepayment risk and a higher risk of default, and may be hard to value and difficult to sell (liquidity risk). They are also subject to credit, market and interest rate risks. The currency market is highly volatile. Prices in these markets are influenced by, among other things, changing supply and demand for a particular currency; trade; fiscal, money and domestic or foreign exchange control programs and policies; and changes in domestic and foreign interest rates. Investments in foreign markets entail special risks such as currency, political, economic and market risks. The risks of investing in emerging market countries are greater than the risks generally associated with foreign investments. Derivative instruments may disproportionately increase losses and have a significant impact on performance. They also may be subject to counterparty, liquidity, valuation, and correlation and market risks. Restricted and illiquid securities may be more difficult to sell and value than publicly traded securities (liquidity risk). Due to the possibility that prepayments will alter the cash flows on collateralized mortgage obligations (CMOs), it is not possible to determine in advance their final maturity date or average life. In addition, if the collateral securing the CMOs or any third-party guarantees are insufficient to make payments, the portfolio could sustain a loss.</sup>