Fixed Income Investment Outlook
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As the years of heavy monetary and fiscal intervention recede into the distance, economies and fixed income markets are increasingly reflecting individual fundamentals, with greater dispersion in interest rates and potential for increased (if still moderate) price volatility.
So far in 2024, the story has largely been one of changing expectations about inflation and interest rates—first bullish, then bearish, then more hopeful again. Developed economies are slowing—more rapidly in Europe than in the U.S.—and inflation has eased, but remains well above target levels. Most central banks remain cautious, seeking to avoid a bounce-back in inflation, but in our view risking downside policy mistakes. In general, we anticipate some further action on rate cuts this year, continuing into 2025 as pricing pressures come under greater control, justifying movement from cash positions into the short to intermediate “belly” of the yield curve.
In credit, we perceive a still-healthy environment, but with cracks around the edges, as lower-income consumers and many companies tighten their belts in the face of higher rates and prices. Although we believe tight spreads remain justified, they amplify the need to look carefully at risk-reward and capitalize on opportunities where they emerge, for example, in agency mortgage-backed securities (MBS), hybrids or local emerging markets, which are benefiting from moderating inflation, better relative growth and appealing real yields.
During an important and turbulent political year, we also maintain an eye toward election results and their policy implications for the future.
Below, we present our key market and investment themes for the coming quarter.
We expect slowing growth and moderating inflation in the second half of 2024. With reduced central bank intervention, risks to growth should be more two-way, with macro forces largely driving outcomes. Longer term, we anticipate more frequent and shorter business cycles given the increased importance of fundamentals over stimulus to economic outcomes. In this environment, higher real rates should be the norm, while the term premium should experience a comeback given growing budget deficits and issues around debt sustainability.
Following a period of surprising resilience, growth expectations remain generally stable, driven by U.S. strength and moderate outcomes in China. The U.S. consumer has been a source of strength, but with rising delinquency rates, lower-income cohorts are pulling back and more affluent consumers, while still healthy, are becoming more selective. While job creation remains strong, labor demand may be slowing. In Europe, affordability has become a key concern, particularly in Britain, while economic strength varies by region; governments may have limited fiscal room to support growth.
The Path May Be Clear, but the Timing Is Not
After an extended period waiting for definitive signs of normalized inflation, central banks remain cautious about cutting interest rates too quickly. Thus, although reductions have begun in Europe, the timing of a meaningful path downward, there and elsewhere, remains uncertain.
U.S. inflation numbers for June were slightly below expectations, appearing to give the Federal Reserve wiggle room to consider a rate cut as early as September. Although we have likely seen the end of improvement in goods inflation, shelter inflation appears to be easing off its peak; meanwhile, core services (ex-shelter) remain a wild card, but should fade next year. In the U.K. and eurozone, elevated wage costs and services inflation, respectively, remain stumbling blocks for monetary easing.
Overall, we currently anticipate two rate cuts this year from each of the Fed, European Central Bank and Bank of England, consistent with market expectations. However, given our awareness of downside economic risks, we anticipate more cuts than the consensus view in each of the following two years before terminal rates are achieved in 2026. Japan represents a significant outlier as authorities seek to transition out of the “lost years” of deflation, with limited rate increases anticipated over the next two years.
Source: Bloomberg, Neuberger Berman. As of June 30, 2024.
Reduced Volatility, Increased Dispersion
Assuming normalized inflation expectations and trend-like growth, we believe current rates are close to fair value. However, uncertainty around central bank policy and the pricing of the term premium could lead to continued (if diminished) volatility and rangebound action.
We also anticipate greater regional dispersion given divergence of economic performance. For example, we take a neutral view of U.S. government bonds in light of the market’s relative economic strength and patience by the Fed, in contrast to the U.K. and Germany, where growth is weaker and (in the case of the U.K.) policy is somewhat more dovish. In contrast, France’s political turbulence and deficit issues are reasons for caution.
Overall, we maintain a focus on short and intermediate maturities given the shape of the yield curve and debt sustainability risks.
In a year when about half of the global population will have gone to the polls, election contests thus far have been a reminder of how results can affect markets based on their perceived implications for policy direction. In the U.K., the Labour Party’s landslide victory was largely expected and the market reaction subdued given anticipation of moderate near-term fiscal changes even amid longer-term concerns. In contrast, the rightward tilt in the EU Parliament followed by a surprise leftist victory in French snap elections sharply widened French/German 10-year government spreads and dampened expectations for continued reforms. Similarly, the election of Claudia Sheinbaum in Mexico spooked investors worried about the continuation/expansion of populist policies. In the U.S., concerns over President Joe Biden’s mental acuity triggered a temporary spike in bond yields in late September as markets anticipated a united government (and thus potentially greater budget deficits) under Donald Trump and the Republicans.
Still, immediate market reactions do not necessarily reflect the nuances. In India, although Prime Minister Narendra Modi’s National Democratic Alliance lost Parliamentary seats, it should be able to execute on already approved reforms, even as further changes may face opposition in the legislature. Despite her progressive profile, Sheinbaum will likely need to work closely with businesses and the country’s northern neighbor, perhaps softening the ultimate impact. In the U.S., neither candidate has appeared committed to reducing spending, making debt sustainability an issue regardless of who wins..
Matures – Part 1
Although corporate spreads are tight relative to history, we believe all-in yields are attractive at these levels. However, given growing strains on the economy, “up-in-quality” credits with defendable balance sheets seem particularly appealing, in our view.
In the U.S., intermediate investment grade corporate credits look attractive to us relative to longer issues as the credit curve remains flat. And despite strong supply so far this year, demand for yield remains robust, creating a technical support for pricing. In looking at this market, we are taking a conservative but opportunistic approach as we consider individual corporate fundamentals with an eye toward idiosyncratic risks and financial policy. Although neutral relative to the overall market, we favor adding risk during bouts of volatility as opportunities arise.
In Europe, credit spreads have tightened this year, even as expectations for lower growth are driving softer near-term earnings estimates. Consumer demand, energy supply disruptions, margin headwinds and refinancing risks could be key drivers in corporate performance. At the same time, fundamentals generally remain solid, providing a buffer against credit deterioration.
Matures – Part 2
In an environment of generally narrow credit spreads, differentiation among segments and issuers has become especially important. We continue to find value within securitized products across various sectors, maturities and risk profiles, observing that spreads remain around long-term historical averages, in contrast to corporate credits.
Specifically focusing on mortgage-backed securities, many issues are trading at a discount, even as higher interest rates have caused prepayment activity to slow, with minimal expectation for a rebound. Positive fund flows combined with attractive valuations have been supportive for the asset class even with relatively modest demand from banks (typically the largest owners of MBS). Historically, U.S. agency MBS have outperformed after a peak in the fed funds rate.
*Currency views are based on spot rates, including carry.