Bonds in brief: January 2024

The views expressed are those of the author at the time of writing. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional, institutional, or accredited investors only.

Welcome to January’s “Bonds in brief”, our monthly assessment of risks and opportunities within bond markets.

Key points:

Fixed income markets started the year with a reversal of the rally that closed out 2023 but the move was partially recouped by the end of January. Credit recorded positive excess returns, driven by fading recession concerns, strong profitability and the growing soft-landing narrative. Issuance of corporate bonds surged, as companies sought to take advantage of bullish sentiment.
Central banks remain on hold, for now, with policymakers waiting to see more evidence of declining inflation before cutting rates. The US Federal Reserve’s confidence in inflation moderating back towards target has grown but policymakers pushed back against a cut as soon as March. The European Central Bank held rates steady, but some members of its Governing Council are floating the possibility of cuts before the summer. The Bank of England (BOE) also kept rates on hold but, notably, one member of the Monetary Policy Committee voted to cut rates immediately.
Economic data currently appears in line with a soft-landing narrative, with the path for inflation in the US relatively clear, at least in the short term. However, we could continue to see volatile data in Europe. This strengthens our view that bringing inflation down from 3% to 2% will be fraught with trade-offs and require careful policy decisions. The challenge for central bankers is even harder in the UK as pre-election fiscal loosening and distinctive structural dynamics — including persistent services inflation, a resilient labour market and accelerating purchasing managers’ index data — may limit the BOE’s ability to follow through on priced-in rate cuts.

What are we watching?

Escalation in the Red Sea. Three US soldiers were killed in Jordan in a drone attack, which was followed by another series of US/UK strikes on Yemen’s Houthis, widening the conflict in the Middle East. In the near term, we continue to see shipping prices rising as cargo carriers are forced to take the much longer route around the Cape of Good Hope. While less impactful than the post-COVID disruption, events in the Red Sea could increase goods inflation. A supply shock through delayed delivery of goods will probably have a more severe impact on Europe, given its open economy and the notable increase in shipping costs on routes between Europe and Asia. While the scale of the shock remains uncertain, it has the potential to impact monetary policy decisions, should it persist.
Cash on the sidelines. Market uncertainty over the last two years has led to record amounts of money being withdrawn from equity and fixed income funds and invested at attractive rates in money market funds. With the prospect of the hiking cycle being definitively over, we could see a significant reversal as investors gain confidence that we have hit the peak in interest rates.
Potential for derailing of the soft-landing narrative. Currently, the data supports investors’ soft-landing expectations, but upside or downside surprises could quickly shift market pricing. While we could see a sudden deterioration in economic conditions, there is a real risk of inflation troughing at a higher level than the 2% target, as labour markets remain resilient and we are starting to see a reacceleration of the cycle. In this context, equity and fixed income markets continue to be disjointed, with government bonds showing much greater volatility than stocks (as well as credit), which continue to price in a more benign macro picture.

Where are the opportunities?

Given how drawn out and uncertain the rate cycle has been, we continue to see opportunities in higher-quality total return strategies that are less constrained by benchmarks.
In our view, core fixed income, and particularly credit, strategies are looking increasingly attractive. Higher-quality fixed income is attractive from both an income and capital protection perspective, with the income from these strategies not only attractive outright but also providing an additional buffer to rate volatility.
We think high-yield and emerging markets debt still offer potential, but we expect continued volatility along with geopolitical risk. High-yield fundamentals may worsen as lagged policy effects work their way through the economy, but corporate earnings have remained resilient so far. Notably, in Europe, we have not seen the same leverage buildup in the high-yield market as we saw in previous cycles.

Expert

Marco Giordano

Investment Director

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