After another volatile year, fixed income is presenting rare opportunities as we head into 2024.
The market consensus is generally that interest rates have peaked – which is exciting news for bond investors.
We share our views across a broad range of teams and asset classes.
Over the last couple of years, bonds have been anything but boring. The low-income environment that the world lived through in the aftermath of the global financial crisis has been completely turned on its head.
First a pandemic, then supply chain disruption, and then the outbreak of war in Europe. Each of these factors contributed to the highest level of inflation experienced in a generation, and a cycle of aggressive interest rate hikes from almost all major central banks.
Against this backdrop, fixed income has defied its staid reputation by experiencing almost unprecedented volatility, and now presents rare opportunities. Put simply, the “income” in “fixed income” is back.
As we head into 2024, the market consensus is generally that interest rates have peaked – which is exciting news for bond investors. We believe the case for the asset class is the strongest it has been for years, with the potential peak in interest rates offering the opportunity to lock in a higher level of income for the years to come.
As we step forward into this new environment, it gives us great pleasure to outline what this means across a broad range of fixed income asset classes. Please read on for further insights and analysis. As always, our teams are on hand to answer any questions you may have.
We expect the global economic cycle to move from a slowdown to a contraction, as this disinflationary backdrop will likely be accompanied by stagnating growth, given both monetary and fiscal headwinds. This scenario will likely favour fixed income, especially higher quality and duration-sensitive assets like investment grade corporates.
Given that yields are the highest they have been since the global financial crisis, we believe we face a once in a generation opportunity to lock in attractive levels of income. Though recession risks will likely rise, we believe that investment grade corporates remain well placed to navigate this backdrop from a fundamental perspective, and spreads are above historical averages. We see the technical picture as supportive as well, as investors rotate out of growth-sensitive investments and into defensive investments.
We see opportunities from a regional, sector and capital structure perspective, given the dispersion and differentiation within the market. As a result, we favour financials. We’re keeping a close eye on subordinated, callable debt issued by European banks; high-quality, longer-term credit in consumer non-cyclical sectors; and sterling-denominated credit from globally diversified corporates.
Furthermore, given a “higher for longer” rates backdrop and weakening growth, we favour being underweight consumer discretionary sectors, real estate investment trusts, and US regional banks.
We believe now is a good time to hold high-quality fixed income assets, as we come to the end of a period dominated by inflation risk and monetary tightening. We think the repercussions of higher interest rates will put pressure on growth, and there is already some evidence of this in labour market and money supply data.
The path of rates and inflation is uncertain, but we think the Bank of England (BoE) is finished with its interest rate hiking cycle and that inflation will continue to moderate. We favour holding duration at this point in the rates cycle. We think the level of yield is attractive and anticipate potential price upside if rate expectations soften.
We have as much duration in our portfolios today as at any time since 2007. Most of the yield we’re earning is from underlying rates. This increases our comfort with high-quality credit, where the balance of return to risk seems good. Because weaker growth will likely be felt most in riskier credit, we favour reducing exposure across higher credit risk markets.
Growth and inflation data are softening in the eurozone, and we think the European Central Bank (ECB) is at the end of its hiking programme. Regardless of the exact path of rates from here, this period has seen the greatest tightening in a long time. We think we are in the right phase of the cycle to hold duration and we have increased our exposure substantially.
We also favour increasing portfolio credit quality and have added core investment grade and senior bank paper. Where we are holding more credit risk, we prefer subordination risk in stronger balance sheets, holding corporate hybrids and subordinated financials.
There are good bonds to buy in the high-quality end of the market, in our view, where strong names are offering some attractive coupons. There are also some good bonds to buy in sectors that have been marked down due to their greater sensitivity to higher interest rates and slower growth.
We are enthusiastic about the yield opportunity in the market overall, but we are taking a prudent approach to credit risk in anticipation of tougher market conditions ahead. The huge move higher in government rates has pushed yields back to levels that were normal for the asset class pre-global financial crisis, but that have rarely been seen since.
However, we are conscious of the risks to the market from deteriorating growth and the more challenging rates environment for high yield bond issuers now. We expect to see more stress in the coming quarters.
We have increased the aggregate quality of our high yield portfolios through active management at the security level. As a result, the allocation to BB rated credits is higher. Meanwhile, the allocation to B and CCC rated credits is lower. Overall credit quality is the highest it has been in several years.
We expect forward-looking total return in high yield to be driven by the starting yield. Current “carry” is attractive by historical measures, and we see little reason to extend the risk profile to “stretch” for yield when the market already offers an attractive starting point.
Yield per unit of duration stands out in the shorter end of the high yield universe. With careful selection, we believe we can generate strong risk-adjusted returns in this segment of the market.
Economic data support rates remaining higher for longer. As such, we view leveraged companies as more vulnerable in a “new regime” of a more permanent, higher cost of capital. We are avoiding lower quality issuers that require cheap financing to survive. Avoiding such issuers also makes sense if we enter a recession.
We are overweight the banking sector. We have consolidated positions from broad-based regional exposure to money-centre banks to reduce risk but capture excess spreads.
We maintain a baseline view that global economic growth will likely be resilient, with a low risk of recession over an investment horizon of six to twelve months. We believe the global monetary policy cycle is peaking, as inflation declines to a level slightly above central bank targets.
We think next year will provide opportunities to capture the real interest rate differential between emerging market and developed market currencies. Currently, real policy rates in emerging market countries are rising as disinflation takes place at a faster speed than in developed market countries.
Over the next six to twelve months, we expect real emerging market policy rates to converge toward those of developed market countries. At that point, our focus will likely shift towards favouring developed market currencies.
Given this outlook, we remain underweight the US dollar versus higher yielding (and higher real yielding) emerging market currencies. We also remain long the US dollar versus lower yielding emerging market currencies, such as the Chinese renminbi and the Taiwan dollar.
We are positive on the outlook for the European bond market in 2024 and expect strong returns, given our outlook for interest rates.
The European economy has been steadily deteriorating over the past 12 months as financial conditions have tightened. While rates have peaked, further tightening will likely be delivered to the economy over the coming months, placing additional downward pressure on growth and inflation.
The ECB has cited the strength of the labour market as a key concern for the inflation outlook, but our analysis indicates that we will see labour markets soften in 2024, providing the ECB with the cover to begin cutting rates sharply as inflation falls back to target.
We expect US Treasuries to deliver positive excess returns over cash in 2024. Risk premia in the US Treasury market are elevated, reflecting a stronger level of growth than we anticipate for the US economy.
As the economy transitions from an above-trend rate of growth to a slower pace, the US Federal Reserve (Fed) should begin cutting interest rates in the middle of 2024. We expect the yield curve to steepen as the market adjusts to slower growth and the likelihood of federal funds rate reductions.
With real yields historically high, US Treasury Inflation-Protected Securities offer substantial value, in our view.
Recent inflation and labour market data have validated the BoE’s decision to pause the rate hiking cycle at 5.25%. Should the current trend towards disinflationary and labour market loosening persist into 2024, it is very likely that the peak of the rate hiking cycle is behind us, shifting the market’s focus to when the BoE might cut rates.
The BoE’s Chief Economist, Huw Pill, has recently characterised its interest rate strategy as akin to Table Mountain, implying a long period of unchanged rates, followed by a rapid normalisation. However, in an apparent contradiction, Pill himself has said market pricing for cuts in the middle of 2024 was reasonable.
Similarly, Governor Andrew Bailey did not push back strongly against market pricing for cuts in the second half of 2024 at the November BoE press conference. As such, it seems reasonable for the market to price cuts in the second half of the 2024.
The extent of cuts is harder to determine. This will hang on developments in the labour market on both the supply and demand side. Should unemployment jump higher than the 0.5% increase to 4.7% by the fourth quarter of 2024, incorporated in BoE forecasts, faster and earlier cuts are possible.
In addition, a better outlook for labour supply and goods supply could lead to a lower trajectory for wages and underlying inflation, allowing cuts at a lower level of unemployment. However, given the uncertainty in the data, it will take some time for the BoE to reach such a conclusion, particularly ahead of annual wage negotiations in the spring.
In addition, global factors will have a strong bearing on the timing and extent of cuts, with the BoE unlikely to diverge significantly from the Fed and ECB. The cutting cycle is unlikely to be as significant as prior cycles, due to a lack of private sector leverage, possible fiscal stimulus into the 2024 general election, and higher global rates.
In addition, there will continue to be upward pressure on term premia due to the large scale of bond supply and ongoing uncertainty about the ultimate path of inflation. As a result, long-term rates could trade lower going forward, but they will probably settle at a higher level than seen in the pre-COVID cycle.
Following the first pause in the hiking cycle from the European Central Bank in late October, both the Fed and the BoE left rates unchanged for the second consecutive meeting in early November.
The Fed also appeared to be more dovish in their recent meeting, highlighting that job gains have moderated, and tighter financial and credit conditions are likely to weigh on economic activity.
Therefore, without a further inflation shock, it appears that interest rates have now peaked for this cycle, which will provide a supportive backdrop for fixed income heading into 2024. However, interest rate futures and ETF flows are showing a divergence of opinion about the outlook.
Markets are currently discounting a gentle easing cycle next year, implying that central banks have managed to bring inflation under control without choking off growth. Meanwhile, flows into fixed income ETFs have recently been dominated by US Treasuries and, more specifically, long-dated Treasuries, as investors increase interest rate risk.
This potentially indicates concern about the economic outlook and suggests investors could be anticipating sharper rate cuts than are currently expected.
Whether markets or investors are correct, ETFs provide a range of targeted exposures to suit your outlook.
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The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.
All information is provided as 28 November 2023, sourced from Invesco unless otherwise stated.
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