Why interest rates will fall in 2023 and how we are profiting

Sam Benstead, deputy collectives editor, at interactive investor:Hello and welcome to the latest insider interview. I am here with Ariel Bezalel, manager of the Jupiter Strategic Bond fund. Ariel, thank you for coming into the studio today.

Ariel Bezalel, manager of the Jupiter Strategic Bond fund:Thank you.

Sam Benstead: We seem to be at a turning point for bonds with interest rates finally rising, inflation quite elevated, but also the risk of recession, so there's a lot going on. What is your outlook for the economy and how are you investing to profit from all this turbulence?

Ariel Bezalel: So, cyclically we see a slowdown unfolding. The first six months, inflation, high inflation numbers were very much dominating the headlines. A lot of that inflation was led by supply-side factors such as a rise in commodity prices, but a lot of that is now starting to reverse. We see a recession unfolding in Europe. We see a slowdown now unfolding in America as well. And also, if you look at America today, the yield curve in America, parts of it is inverted, which typically tells us that the growth outlook is becoming more and more challenged as well.

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We're also seeing a number of signs that the likes of the housing market is slowing down, that's close to 20% of GDP in America, and we are also seeing signs that the US consumer is now starting to come under pressure. The cost of living is really beginning to hamper the US consumer, and undoubtedly the Russia-Ukraine war, which is on the doorstep of Europe, of course, is creating all sorts of profound issues for Europe and making it very difficult for the European Central Bank to conduct monetary policy for a whole host of factors.

Combined with this, we are also seeing money supply growth slowing down quite sharply as well in a number of regions, so that tells us that in the coming months, over the next 12 months, inflation is likely to be less of a problem. And so in terms of how that translates into the portfolio, we think government bonds are going to have a better second half of this year, so we have been allocating more to government bonds and we have also been cherry-picking across investment grade and high yield, where for the first time in quite some time we are beginning to find some really compelling opportunities.

Sam Benstead: You said inflation was going to come down. Where do you think it will settle at?

Ariel Bezalel: I think inflation is unlikely to hit the central bank's 2% target. Typically, that's what the major central banks of the world typically target, more or less. We think inflation around Q3, Q4 is probably set to fall, and come down and roll down, probably quite rapidly, unlikely to get anywhere near the central bank's target.

We are probably likely to get to the central bank's target at some point next year, but I can see us, I mean, on the headline rate in America, for example, we are probably set to go to six, and maybe at the core rate, somewhere about four or below four. But it doesn't necessarily mean central banks ease off the brakes in terms of rate hikes and wait for that 2% target to be hit.

You've got to bear in mind, if you go back to July 2008, inflation was running at 5.6% pre-great financial crisis. The Fed was already cutting rates because they saw a decent slowdown unfolding. And then a year later, in July 2009, inflation was running at minus two. So I think the thing that a lot of people forget is inflation is about persistent price hikes. So, yes, the oil price is high. Is it going to go a lot higher in a slowing global outlook? I'm not so sure. Maybe, I don't think so. And commodities in general are now coming off pretty sharply. And that should help the inflation numbers improve somewhat over the next six to 12 months.

• Watch the other part of this video interview with Ariel Bezalel: an 8% bond yield and the ‘biggest opportunity’ for years

Sam Benstead:And when do you think central banks will start cutting interest rates? And is that going to be great for bonds or are you going to be focused on the economy and recession risk and perhaps default risk?

Ariel Bezalel: As we go into September/October, I think the Federal Reserve are going to become a bit more hesitant in terms of hiking rates. I think there's going to be mounting signs of an economic slowdown unfolding. In America alone, across bonds, crypto and equities, we've seen about $15 trillion of losses. Now that's quite a bit of wealth destruction there, which is equivalent to around about nearly two-thirds of US GDP.

Globally, the number so far is about $35 trillion or so, to a global GDP of about $90 trillion. And I think there's a risk that asset prices could come under further pressure in the months ahead. That, combined with, like I said, more signs of a slowdown, I think by September/October, the Federal Reserve is likely to pause, and then typically the Fed waits five to six months before they carry out a rate-cutting cycle or programme, and so I'm thinking around about Q2 to Q3 next year is when they [will] start actually cutting rates.

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Sam Benstead: So there's a lot happening at the moment. How active have you been this year and are you anticipating more rate cuts next year than the market or perhaps fewer?

Ariel Bezalel: Over the course of this year, as government bond yields have been shooting higher, we have been increasing the duration of the portfolio by buying bonds of high-quality sovereigns such as the US, the likes of Australia as well, where we are beginning to see the housing market coming under pressure.

Our view is that, as the year unfolds and the data starts to signify a slowdown, we should start to see yields coming down quite aggressively in the second half of this year. Now, the market is saying that in America, for example, rates are set to hit 3.5% by the end of this year, peak at 3.5%, and then come down over the course of 2023, and we should see about 50 basis points of cuts or so.

I'll be surprised if we do get as high as 3.5%, and I think the cuts are going to be somewhat more aggressive as the inflation picture turns around pretty dramatically, pretty swiftly. What I would also add is, as we look at the longer-term picture, I think the inflation picture is a bit uncertain on a kind of multi-year view, and that's because I think governments have found a new toy. That's fiscal policy, which was introduced during Covid. And I can see the active use of fiscal promoting more of an inflationary backdrop than we have seen in recent years. So I guess what I'm saying here is that I see a cyclical downturn, but maybe inflation on a secular view being a bit more elevated than in the past.

Sam Benstead: In the top 10 positions of the funds, there is no UK government debt, but you do own American and Australian debt. Why is that, and what do you make of the recent political turmoil in the UK and does that affect your view on the country's debt?

Ariel Bezalel: Yes, it does. The political uncertainty can never be a good thing for UK PLC, for the government. We've seen what the political turmoil has done to the currency. Sterling has been incredibly weak this year, but having said that, the dollar has been strong against everything. But, you know, sterling in isolation has not been a great performer this year. The political turmoil is a big factor there. And also the Bank of England, to an extent, I think, have lost a bit of credibility as well.

And so with all that thrown into the mix, to sleep easy at night, we think that the likes of the US, Australia and even New Zealand as well, where we've been building up exposure, the economic fundamentals look more appealing, and we think the yields, which are considerably higher actually, in America today the 10-year is a bit below three, gilts are a bit above two on the 10-year.

In Australia, on the 30-year, you can get yields of a bit less than 4%. So there's a lot more scope for these yields to go down over the coming six to 12 months as the global economy slows down quite sharply. So there's a number of factors there as to why we are playing those countries as opposed to the UK.

Sam Benstead: Quantitative easing (QE) has been a key tool for central banks for the best part of a decade. That is now unwinding and central banks are going to start selling their bond portfolios, particularly in the UK, from September, I think. So what does that mean for the fixed income markets?

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Ariel Bezalel:In the past, as QE has been initiated, you tend to get a rise in yields as, and that's a bit perverse actually, because people think that buying government bonds should leads to yields going down when the central bank, rather, is purchasing government bonds. Historically, it's actually led to yields going up, as investors are forced out on to the risk spectrum. So, rather than holding government bonds in a world flooded with liquidity, they'll then buy equities, credit, emerging markets, what have you.

My concern now is the Federal Reserve and the likes of, as you mentioned, the Bank of England, set to implement quantitative tightening (QT) and reduce their balance sheets and effectively exacerbate the shrinkage in liquidity that we've seen in recent months. My concern is that we could once again have a bit of a round trip in government bond yields as really the reverse happens where investors are encouraged to go back up the risk spectrum whereby they are moving into high-quality assets such as government bonds. And the Federal Reserve are expected to accelerate their QT programme from $47.5 billion a month today, and in September it goes up, I think, to about $95 billion a month. And I think that acceleration in QT could present all sorts of problems, and that's why we are thinking the problems could be too much for the global economy to bear, and why we think the Fed might go on hold come later this year.

Sam Benstead:Finally, the question we ask all our guests, do you personally invest in the fund?

Ariel Bezalel: Yeah, absolutely. I've got a significant amount of my own wealth in the portfolio today in strategic bond.

Sam Benstead:Ariel, thank you very much for coming into the studio.

Ariel Bezalel:It's been a pleasure. Thank you.

Sam Benstead: And that's all we have time for today. You can check out more videos on the interactive investor YouTube channel where you can like, comment and subscribe.