Fixed Income Investment Outlook
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The wait for monetary easing by the U.S. Federal Reserve is finally over, with the announcement of a 50-basis-point rate cut in September, starting what will likely be a series of reductions over the next year. Various other developed market central banks had already started to ease, but the move provided general comfort for these campaigns amid progress on inflation and fears of excessive economic weakness. Japan’s move toward higher rates remains an outlier, although its increases from here should be moderate.
The world’s economic trajectory appears mixed, with the U.S. likely to avoid recession and Europe more stressed by manufacturing and consumer weakness. China’s structural issues remain a concern, even as monetary and fiscal authorities have moved to support domestic sentiment. Emerging market economies remain resilient overall. In our view, key issues include the current U.S. election cycle and geopolitical developments, as well as two-way risks associated with an inflation rebound or excessive weakness.
From an investment perspective, the force of rate reductions should support fixed income assets, particularly on the shorter segment of the yield curve, although we believe markets may be overly optimistic on the initial pace of the cuts, leading to caution on duration and potential opportunity in inflation-linked securities. In terms of credit, technical demand along with extended maturities and constructive fundamentals have kept spreads narrow, so we are looking for select opportunities leveraging credit research. We continue to favor structured credits both for yield and defensive characteristics, even as our exposures have eased somewhat due to pricing improvement. In our view, emerging markets debt is also appealing given constructive fundamentals and past strength in Fed rate-cutting cycles.
Our key investment themes and market views are provided below.
The U.S. economy continues to slow, but appears likely to avoid recession. U.S. inflation has been declining steadily, and the Federal Reserve’s focus has shifted toward maintaining employment as it begins its easing campaign. The country’s job growth has become increasingly concentrated, with education and health accounting for nearly half of gains over the past year, even as they have yet to return to pre-pandemic levels. Initial jobless claims and the unemployment rate, although ticking up, remain muted in historical terms.
In Europe, conditions are weaker, with PMI reports in Germany and France showing continued stagnation, while fiscal measures have been less accommodating, creating a headwind to growth. Inflation readings have been coming in generally in line with market expectations, even as services prices remain a little sticky. Potentially bolstering the global economy are China’s recent stimulative moves, including monetary easing, property sector supports and capital injections at banks. However, the scale and scope of these measures may be only enough to affect the global economic picture by creating something of a buffer against deflationary forces.
In our view, the Fed’s large initial rate cut in September should be viewed as a catch-up measure, acknowledging that it might have cut rates in July with full information about pending U.S. payrolls. From here, we believe the Fed will likely move into a phase of data-dependent quarter-point moves, including two more cuts in 2024, and finish off with a neutral rate of around 3.25% toward the end of next year. The market, in contrast, anticipates a more front-loaded 75 basis points of cuts in 2024 and a terminal rate of 3.00%.
In Europe, ECB President Christine Lagarde has voiced increased confidence in the central bank’s ability to cut rates after its initial reduction over the summer; in our view, two more cuts are likely this year from the ECB and from the Bank of England in light of sluggish growth and weak confidence levels. Lower-than-expected inflation readings in the euro area have reinforced that easing trajectory.
While the Bank of Japan remains in tightening mode, we anticipate just one further increase in 2024 and a cautious monetary stance overall. Depending on the impacts of its measures so far, China may seek to further loosen financial conditions. And although many emerging markets central banks acted earlier to tighten than developed market counterparts, the Fed’s moves should provide space to loosen where that process has not started already.
NR = Neutral Rate
With the closely contested U.S. election fast approaching, we see potential for increased market volatility and longer-term policy impacts across sectors.
The Republican candidate, former President Donald Trump, is seeking to further reduce corporate tax rates, particularly for companies producing goods domestically, and extend the lower individual tax rates established in 2017. His opponent, current Vice President Kamala Harris, would like to raise corporate taxes, and, while extending and expanding tax breaks for the middle class, increase levies on wealthy Americans. In the business sector, Trump has emphasized opening up traditional oil and gas exploration and production, while reducing regulation across the commercial landscape. Harris, in contrast, has advocated for clean energy and government intervention in the economy to help drive growth. Trump favors the use of broad tariffs on imports and has proposed more stringent levies on Chinese goods, while Harris would take a more limited approach.
The degree to which the candidates can implement their ideas depends on broader federal election outcomes. Assuming the currently expected split government, with a Republican Senate and Democratic House of Representatives, legislative action will likely require compromise. Neither side has talked meaningfully about how to reduce the growing U.S. fiscal deficit.
Over the past year, the bond market has frequently been disappointed in the timing and pace of potential easing by the Fed. Although recent data has generally reinforced the downward trajectory of the fed funds over the next year, recently strong employment numbers provided a reminder of the central bank’s data dependency, and the potential for a slower trajectory than expected should the economy and inflation maintain their resilience.
Of course, should economic and, in particular, employment statistics turn south from here, we could see an acceleration in accommodation. The Middle East conflict and China’s recent stimulus have added new wrinkles, as further increases in oil prices could add to headline inflation, while China’s measures have probably established a buffer against global deflation risk.
All this points to our relative caution on duration, even as the longer-term trend for rates is downward. For those who wish to gain some early exposure to duration, we favor investments in real rates via inflation-linked securities as any temporary upticks in yield will likely occur in nominal terms. Agency mortgage-backed securities may also be a part of duration positioning, offering higher yields than equivalent Treasuries and potentially generating more price return with the eventual reduction of interest rates.
Keep in mind that the picture for U.S. longer-maturity bonds is somewhat more convoluted than for shorter maturities, given concerns about fiscal policy and debt sustainability over time. Indeed, longer U.S. Treasuries may stagnate or face upward pressure as debt rises as a percentage of GDP and takes up an ever-greater portion of federal spending. European debt levels, while still elevated from pandemic-era spending, appear to be moderating as a percentage of GDP, though slowing spending may actually hinder recovery from here.
At the start of the year, we noted that supply-and-demand fundamentals could be a driving force of credit spreads this year, something that has emerged amid an ongoing bid for yield and appetite for risk. This has been coupled with continued solid corporate fundamentals, reflected in stable leverage and still ample cash positions. U.S. high yield spreads remain at roughly average historical levels, while capital markets remain open even to more stressed issuers. Generally, spreads remain exceptionally tight, and could stay range-bound in the coming months due to technical forces.
Overall, a focus on quality and exploiting dislocations makes sense to us, along with a broader view as to potential opportunities in order to capitalize on appealing all-in yield. Collateralized loan obligations, for example, are increasingly viewed as defensive against a slowing economy, given their often-senior position in the capital stack and expectations for a terminal rate above pre-pandemic norms. Although less than in recent quarters, agency mortgage-backed securities remain a key theme for us, offering appealing yields, but also likely to benefit particularly from easing short-term rates. Various other areas of structured credit, such as commercial mortgage-backed, asset-backed and residential mortgages could see fundamentals improve as lower rates reduce finance costs. Hybrid securities, meanwhile, are offering yields far wider than our estimate of fair value versus other opportunities.
Emerging market debt (EMD) stands to benefit from slower but not recessionary U.S. growth, lower global yields and a wider growth advantage for emerging versus developed countries. The asset class has tended to perform well after Fed hiking cycles. Should investor sentiment improve, an acceleration in flows could be a tailwind for EMD.
EM inflation rates have declined toward central bank comfort zones, suggesting that further disinflation could be more modest. Still, attractive real yields and monetary policy biased toward easing should support local bond performance. Forward interest rate differentials versus the U.S. due to Fed easing should provide support for EM currencies, which could also benefit from robust macro fundamentals and (outside Asia) high carry.
China continues to announce stimulus measures that may have a moderately positive impact on economic growth and limit downside risks, but will need to be more comprehensive in order to broadly affect bond market fundamentals. More broadly in the sovereign debt space, default risks appear limited in the coming months, as more vulnerable issuers have managed to secure new funding, while various countries’ increased engagement with the International Monetary Fund should support funding needs and reform agendas.
Among EM high yield corporates, default risk has also been declining, with our 2024 forecast now 3.2% compared to last year’s 7.8%. Earnings growth is generally improving, while balance sheets are benefiting from elevated liquidity buffers. Deeply negative net issuance should also remain a positive technical for EM corporates. Lower-rated bonds appear to offer value, and we see opportunities for spread compression in specific issuers.
*Currency views are based on spot rates, including carry.