Bullish bonds, bearish risks and youthful reds
I’m not going to go on about the great bond rally we enjoyed in November. After all, I got it wrong during the third quarter (Q3) when the US economy boomed and the fear was interest rate cuts were a very distant possibility. But now my “bonds are back” mantra looks more credible, with markets more confident about lower rates next year. There are still attractive bond strategies to choose from. Meanwhile, equity and foreign exchange volatility is priced incredibly low. This looks odd given the risks in the global economic and political outlook. Declines in rates will provide some support to risky assets. However, hedging for a less favourable outcome – one in which central banks baulk at the priced-in rate cuts – might not be a bad strategy as we go into 2024.
There are still legs to the short-duration fixed income trade
If we are to believe central bankers, interest rates will be on hold at current levels for a prolonged period. Our central case is that we will see lower rates in 2024 but cuts will not start in earnest until the second half of the year. There are two things to consider. First, this represents a good running yield for the next couple of quarters with corporate bonds adding the additional yield above the central bank overnight rates. Second, when markets become more confident about rate cuts, bond prices will rally.
The best entry point may already be behind us. Compared to where the US Federal Reserve (Fed) Fed Funds Rate is today, the market is pricing in 125-150 basis points (bp) of rate cuts by the end of 2024. Looking at the US Corporate Bond Index (ICE/BofA), the yield on the one-to-three-year bucket has fallen 50bp from its October high. The market is getting more enthusiastic about potential rate cuts in 2024. For the US, given market pricing, the initial rate cut is now priced as early as May.
Having said that, short-maturity yields are still attractive and will benefit from both carry and capital gains when the rate cycle turns.
Downside economic risks favours adding to long duration
Once the market gets wind of the central bank pivot, the second phase of the long-bond rally can get underway. The first phase was the retreat from the symbolic 5% yield on the benchmark US 10-year Treasury note from 23 October. The second phase will recognise that rates are on a path towards a new equilibrium which is higher than what prevailed before the pandemic but is lower than the peak we will have lived with for the best part of a year. This should potentially mean even lower yields and decent total returns for fixed income investors. Being long duration (in the face of weakening growth) and hedging against a potential re-emergence of rising inflation might appeal to some investors.
How much disinflation?
This is the key question because it will not only determine how quickly rates are cut but it will also dictate how much nominal GDP growth will slow (N.B. inflation boosted nominal growth). This meant corporate revenues, wages and governments’ tax takes were higher than anticipated. Slower nominal demand means there may be disappointment on these fronts. This has implications for equity markets in as much as the strength of revenue growth will impact earnings per share and total returns for equity investors. It tends to support the investment case for quality growth in equity markets – investing in those companies that can continue to generate strong sales and profits growth. Slower revenue growth will also work against any further improvements in leverage ratios, something which corporate bond investors need to watch carefully. As such, quality will also be a key factor in credit markets and with yields still high, it suggests allocating to those companies and sectors with better quality balance sheets. Slower growth in nominal GDP is not good news for governments either, as tax revenue growth may disappoint and this will impact on deficits, given that spending levels tend to be more contractual. This risk to fiscal stability is the main concern for medium-term investors in government bonds.
Dealing with risk
Market commentators always like to highlight risks. There are many to choose from but as we contemplate the new year there are a few top of the mind. The two wars that are underway continue to threaten energy supplies and thus create uncertainty over future energy prices. Equally, this threatens the soft landing turning into stagflation. Through both the war in Ukraine and the conflict in the Middle East, the outlook for peace and security is unclear, meaning nervousness prevails in diplomatic circles. Public spending on defence and security has ramped up. This does not help the fiscal outlook. Moreover, trade and travel could face disruption. Widening the geopolitical scope, China’s desire to enlarge its sphere of influence has already provoked a reassessment of supply chains and trading relationships. The materiality of these risks in terms of major disturbances to economic activity or global peace is difficult for investors to assess but does feed into support for a more risk-averse stance.
One measure of risk, the VIX – or so-called fear index - is currently at an exceptionally low level. This indicates that investors are not buying uncertainty protection. It is possible there are lots of investors still invested mostly in cash that have no need for hedging, or they feel day trading or relying on exchange-traded funds means they can get out of positions easily if things start to turn south. I for one think this is a massive opportunity to buy protection when there are risks from both the macro outlook and the geopolitical landscape. In another large liquid market – foreign exchange – volatility is also low.
Politics is more uncertain
Focus will be on the US election in 2024 but there could also be an election in the UK and there are numerous others around the world including in Mexico, India, Indonesia, Taiwan, and a Presidential election in Russia (I wonder who will win that?). To me, global politics is currently not a source of hope for more stable growth. Western democracies are under threat from nefarious global players and from within, as incumbents and mainstream politicians face criticism of how they have managed issues including immigration, climate change adaption and the pandemic. Populism is a threat to market-based social democracy, as we have seen with the recent election in the Netherlands and with Donald Trump being in pole position in US opinion polls. Populism creates uncertainty which threatens economic stability. Risk premiums do not reflect that.
Lower global rates should eventually help growth. But it is not sufficient because rates are not going back to the levels seen post-2009. Fiscal policy is hamstrung by large deficits and increased debt service costs. Global trade, as a force for generating increased wealth, is not exactly going into reverse but is not the force it once was given US-China tensions, sanctions on Russia and the desire of a vocal but powerful minority in some European countries to follow the British example and leave a trading and economic block that is the best chance of securing stable and strong economic growth. China’s positive impact on the rest of the world that came from its membership of the World Trade Organization and the rapid growth in its low-cost manufacturing model has all but gone. There are plenty of reasons to be gloomy.
Where could growth come from?
I have previously written that artificial intelligence is certainly one hope, as it boosts productivity, and is something tangible that equity investors can focus on. A general increase in labour participation rates would also be useful in boosting potential growth. The further mobilisation of capital to support an acceleration of sustainable practices across a range of sectors would also be helpful, particularly if it can be directed at sustainable and local energy provision and agricultural practices in the Global South. News that COP28 host, the UAE, is to launch a $30bn fund to tackle climate change is welcome. Indeed, increased investment in the energy transition, in sustainable agriculture which reduces biodiversity loss and increases yields - and in biotechnology that contributes to reductions in chronic medical conditions which put enormous strains on health systems, would be growth accretive and have positive social effects. Obviously, an end to conflict in Ukraine and the Middle East would be positive, especially if peace agreements paved the way to reconstruction in the areas most devastated by conflict.
Our own Outlook describes 2024 as a mid, rather than end-of-cycle episode. That means we do not expect the widespread destruction of jobs and businesses typical of a recession. That is cause for comfort at least. At the same time, I struggle to see much upside. Hence the preference for more certainty rather than speculation in expected returns (bonds, quality growth in equities, and so on). There is no question, however, that an end to the current two conflicts and even more rapprochement in US-China relations would be reasons for risk-on. European equity markets could respond positively to an end to the war in Ukraine as it would lessen concerns about energy security and provide growth opportunities that would stem from the ultimate accession of Ukraine to the European Union.
To end on a positive note
I am still enjoying watching replays of Alejandro Garnacho’s bicycle-kick goal for Manchester United against Everton last week. It was stunning and highlighted the potential of the 19-year to be a future superstar. Indeed, the youth pipeline for United is strong, as it has always tended to be. Overall, there has been an improvement although giving up a 3-1 lead against Galatasaray in Istanbul in the Champions League highlights the need to improve in certain areas (midfield, the goalkeeper, Bruno Fernandes’ tendency to give away cheap free kicks). Qualification for the knock-out stages of the Champions League looks remote now but United are in a good position in the Premier League and without the distractions of Europe, could mount a serious attempt on a top-four position come the end of the season. And they are building a solid group of young skilful players such as Garnacho, Rasmus Højlund, Facundo Pellistri and Kobbie Mainoo. The future is bright, young and red.
(Performance data/data sources: Refinitiv Datastream, Bloomberg, as of 30 November 2023). Past performance should not be seen as a guide to future returns.