- Fixed Income Portfolio Manager
United States, Institutional
Change
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A global shift toward easing by central banks has historically rewarded fixed income investors. In the first half of 2024, however, this tailwind weakened as robust economic data tempered rate-cut expectations. At the start of the year, many anticipated significant rate cuts from the US Federal Reserve (Fed) to mitigate growth risks, with futures markets pricing in 150 basis points (bps) of cuts by year end. As we enter the second half of 2024, only about 50 bps of cuts are expected, amid persistent inflation and resilient consumer spending. This uncertainty about monetary policy, combined with geopolitical tensions and the upcoming US elections, may lead to market volatility, presenting opportunities for active sector rotation and duration management.
Will the Fed cut rates?
Recent data has led several central banks, including the European Central Bank, the Bank of Canada, and the Swiss National Bank, to cut rates this year. In the US, however, higher-than-expected inflation has forced the Fed to balance two aspects of its mandate: stable prices and full employment. US GDP growth was weaker than expected in the first quarter, and sentiment indicators of manufacturing and consumer confidence have faltered. The labor market shows mixed signals, with fewer job openings and reduced wages counterbalanced by strong payroll growth and a low unemployment rate of 4.0%.
While inflation has fallen from its 2022 peak, the Fed’s preferred inflation gauge, core personal consumption expenditures (core PCE), was 2.8% year over year in April (Figure 1). We believe inflation may level out near 3%, above the Fed’s 2% target. If inflation remains elevated, policymakers will need to decide whether to prioritize growth risks or their inflation-fighting credibility. We expect steady growth and labor market conditions, making it unlikely the Fed will meet market expectations for rate cuts this year.
Figure 1
Expect range-bound yields
Inflation will continue to play a crucial role in determining the direction of interest rates and the performance of credit sectors. In the absence of major shocks, stable inflation should lead to lower interest-rate volatility, with US Treasury yields remaining relatively stable. Current yields in most developed markets offer an opportunity for investors to move out of cash. While money market rates are appealing, many bond portfolios currently offer higher yields than cash.
Furthermore, there are risks to staying in cash, such as reinvestment risk and duration risk. By reinvestment risk, we mean that short-term rates can drop quickly, particularly during economic slowdowns, forcing cash investors to reinvest at lower, less attractive rates. Duration risk is the risk that cash investors assume by keeping their investments in short-duration bonds. Falling interest rates typically lead to capital appreciation in longer-duration bonds, which cash investors would miss out on.
High-quality fixed income has typically played a valuable role in diversifying investors’ portfolios. Longer-maturity bonds often serve as a counterbalance to stocks, historically rising in value during periods of stock market declines.
Maintain a conservative credit risk posture
Spreads across most fixed income sectors remain compressed relative to history, with limited potential for further tightening. We expect moderate economic growth and strong corporate fundamentals. Economies have been more resilient to higher rates than in previous tightening cycles. We do not foresee the significant spread widening typical of downturns but expect periods of weakness that will present opportunities to add risk. Elevated yields will likely continue to attract demand for fixed income. Dispersion in valuations among fixed income sectors and regions will present opportunities for alert investors to take advantage of market dislocations.
Seek value beyond traditional credit markets
Some credit market sectors that we have historically favored offer less value currently. Investment-grade and high-yield corporate credit spreads are narrow, and spreads on hard-currency (i.e., US-dollar- and euro-denominated) emerging market sovereign bonds are at historically tight levels. Subordinated debt from European banks (contingent convertibles or “CoCos”) has performed well but offers less favorable risk/reward now.
We see better opportunities in securitized sectors tied to the US consumer and housing market. True convertible bonds (distinct from CoCos) are likely attractive due to their equity-linked performance, which can allow them to outpace corporate bonds with tight spreads in bullish scenarios. Figure 2 illustrates potential excess return forecast scenarios.
Figure 2
Where do we see compelling risk/reward opportunities?
- Convertible bonds: Compared to other high-yield sectors, convertible bonds look attractive, with the potential to perform in line with other asset classes in a bearish risk scenario and to significantly outperform in a bullish environment. Convertibles can also provide industry diversification to many fixed income portfolios, as they are exposed to sectors like technology and life sciences that are not well represented in traditional public fixed income markets.
- Agency mortgage-backed securities (MBS): MBS have attractive spreads relative to corporates and are likely to be supported by renewed demand from banks and stable interest rates.
- Auto loan asset-backed securities (auto ABS): Lending standards to car buyers have tightened substantially over the past year, even as spreads on auto ABS bonds have widened. We think auto ABS, particularly those focused on subprime auto loans, are an underappreciated opportunity in fixed income markets.
- Residential MBS (RMBS): The most important fundamental variable for RMBS performance is home-price appreciation. Structural supply shortages of housing and pent-up consumer demand for new housing in the US imply that home-price performance should remain robust.
Which sectors do we find less appealing?
- Long-duration investment-grade corporates: Tight spreads are the biggest obstacle to further corporate bond performance. Investment-grade corporates also may see their margins come under pressure as pricing power subsides.
- Emerging market sovereigns: While emerging markets have benefited from solid global growth, there is little room for spreads to tighten further. Hard-currency spreads are very tight, particularly for investment-grade issuers.
- Contingent convertible securities: CoCos have appreciated considerably since their lows last year following Credit Suisse's failure. We do not have fundamental concerns about European financials, but they are not as attractively valued as they were a year ago.
Preparing for election-related volatility
The upcoming US election and ongoing geopolitical tensions are likely to cause market volatility. We are optimistic about market resilience regardless of the election outcome and prefer to buy risk assets during bouts of pre-election volatility.
Investors should remain vigilant and proactive, ready to capitalize on market dislocations as they arise. This environment calls for a flexible, dynamic approach that leverages diverse high-yielding opportunities and manages risks carefully. By staying nimble and strategically positioning portfolios, investors can turn market uncertainty into a powerful advantage, driving both yield and total return in 2024.
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Monthly Market Review — August 2024
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Brett Hinds
Jameson Dunn