Consensus has embraced the notion that the global economy is now a very different structural environment. But do realities test this very persuasive thematic?
Higher for longer? Be careful what you wish for…
The global economy is highly indebted and financialised, and higher interest rates do matter.
The enlarged “financial economy” won’t enjoy adjusting to a higher cost of capital world. For growth to remain resilient, we believe the global economy will require lower interest rates.
Brave new "fiscal" world? If only it were that simple...
Ongoing use of fiscal policy is the new reality, who will fund this?
With government deficits already considerable – and in a world with fewer buyers of US Treasuries – the risk of long-end bond volatility and higher yields is increasing. While timing is uncertain, more liquidity seems inevitable.
Brett Lewthwaite
CIO and Head of Fixed Income
- Economic downside risk remains elevated, and as such we see value in a more defensive positioning given the balance of risks.
- For the time being, we prefer to stay liquid, stay longer duration, and remain patient for better entry levels in credit markets.
- While we are wary of the inevitable greater use of fiscal policy and its increasingly concerning impact on government financing, as well as its potential to create stickier inflation, we sense the sequence is bond yields down first, with perhaps greater bond yield curve volatility.
- At the beginning of 2024, we saw yields drift higher, and they are consequently screening more attractive. Given that inflation has come down meaningfully since its peak and interest rates remain in restrictive territory, we are constructive on duration and utilise it as our main lever to express our defensiveness.
- Geographically, we favour regions that are showing greater signs of economic weakness and resultingly have central banks willing to cut before the US Federal Reserve (Fed).
- Within the US, we prefer the shorter end of the curve, expecting some steepening as rate cuts finally eventuate and term premiums normalise.
- Credit markets have been supported by a benign fundamental backdrop with earnings more resilient than previously feared and interest coverage declining but from a high base. Ratings upgrades have outpaced downgrades, and technicals remain supportive (high demand from all-in yield buyers and expected lower supply until 2025).
- Despite this mildly positive outlook, credit spreads are markedly tight, resulting in our neutral view on a credit duration basis. We prefer a position of yield advantage – utilising preferred securities and Additional Tier 1 (AT1) bonds. We also see select opportunities in industrials (given the macroeconomic backdrop), banks, and the ends of the curve in non-financials that offer higher-coupon and/ or lower-priced bonds.
- Emerging markets (EM) have continued to show their resilience. Spreads are tight, and we expect they will continue to trade in line with developed markets credit. At current spread levels, we exercise some caution and maintain a neutral view.
- Though we continue to seek out opportunities, we are seeing more improving outlooks in the BBB and BB rating buckets. For hard currency corporates, we favour those with strong balance sheets, issuing higher coupon bonds. Similarly for sovereigns, we prefer countries with sound economic policies and adequate buffers. While in EM currency-denominated debt, we await further US dollar weakening to increase exposures.
- Spreads on structured securities have largely rallied since our last Strategic Forum, though they have lagged their corporate credit counterparts.
- With value still on offer, we retain a constructive view on our preferred sectors. Namely, higher-quality issues in the residential space (US non-agency and Australian residential mortgage-backed securities). We also view short duration prime AAA-rated asset-backed securities as attractive, given current underlying loan performance and yield profiles.
- We are wary of commercial real estate and sectors that are exposed to lower-quality borrowers, both of which continue to show signs of stress.
- USD – likely to trend lower after its structural peak in 2022, though the trajectory may be volatile as expectations on interest rate differentials evolve.
- EUR and GDP – broadly neutral view. While both have central banks looking likely to cut before the Fed, neither is likely to deviate too far from Fed policy.
- AUD – cautiously positive, given its historically cheap valuation and potential to perform on positive risk sentiment.
- JPY – rates differentials continue to signal long-term weakness, though we are cognisant of intervention by the Ministry of Finance and Bank of Japan.
Previous Fixed Income Strategic Forum insights
One of the challenges with investment management is balancing the short-term noise of financial markets with a longer-term assessment of the investment and economic landscape. The Fixed Income Strategic Forum brings together more than 130 investment professionals and operates to establish our medium-term views and strategic portfolio positions. Check out previous Strategic Forum insights below.
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Diversification may not protect against market risk.
Fixed income securities are subject to credit risk, which is the risk of loss of principal or loss of a financial reward stemming from a borrower’s failure to repay a loan or otherwise meet a contractual obligation. Credit risk arises whenever a borrower expects to use future cash flows to pay a current debt. Investors are compensated for assuming credit risk by way of interest payments from the borrower or issuer of a debt obligation. Credit risk is closely tied to the potential return of an investment, the most notable being that the yields on bonds correlate strongly to their perceived credit risk.
Fixed income securities are also subject to interest rate risk, which is the risk that the prices of fixed income securities will increase as interest rates fall and decrease as interest rates rise. Interest rate changes are influenced by a number of factors, such as government policy, monetary policy, inflation expectations, and the supply and demand of securities. Fixed income securities with longer maturities or duration generally are more sensitive to interest rate changes.
Fixed income securities may also be subject to prepayment risk, which is the risk that the principal of a bond that is held by a portfolio will be prepaid prior to maturity at the time when interest rates are lower than what the bond was paying. A portfolio may then have to reinvest that money at a lower interest rate. Market risk is the risk that all or a majority of the securities in a certain market – like the stock market or bond market – will decline in value because of factors such as adverse political or economic conditions, future expectations, investor confidence, or heavy institutional selling.
Credit risk is the risk of loss of principal or loss of a financial reward stemming from a borrower’s failure to repay a loan or otherwise meet a contractual obligation. Credit risk arises whenever a borrower expects to use future cash flows to pay a current debt. Investors are compensated for assuming credit risk by way of interest payments from the borrower or issuer of a debt obligation. Credit risk is closely tied to the potential return of an investment, the most notable being that the yields on bonds correlate strongly to their perceived credit risk.
Currency risk is the risk that fluctuations in exchange rates between the US dollar and foreign currencies and between various foreign currencies may cause the value of an investment to decline. The market for some (or all) currencies may from time to time have low trading volume and become illiquid, which may prevent an investment from effecting positions or from promptly liquidating unfavourable positions in such markets, thus subjecting the investment to substantial losses.
Equity securities are subject to price fluctuation and possible loss of principal.
International investments entail risks including fluctuation in currency values, differences in accounting principles, or economic or political instability. Investing in emerging markets can be riskier than investing in established foreign markets due to increased volatility, lower trading volume, and higher risk of market closures. In many emerging markets, there is substantially less publicly available information and the available information may be incomplete or misleading. Legal claims are generally more difficult to pursue.
Liquidity risk is the possibility that securities cannot be readily sold within seven days at approximately the price at which a fund has valued them.
Market risk is the risk that all or a majority of the securities in a certain market – like the stock market or bond market – will decline in value because of factors such as adverse political or economic conditions, future expectations, investor confidence, or heavy institutional selling.
Mortgage-backed securities (MBS) and asset-backed securities (ABS) are subject to credit risk and interest rate risk and may also be subject to prepayment risk and extension risk. In addition, MBS and ABS may decline in value, become more volatile, face difficulties in valuation, or experience reduced liquidity due to changes in interest rates or general economic conditions. Certain MBS, such as collateralized mortgage obligations, real estate mortgage investment conduits, and stripped MBS may be more susceptible to these risks than other MBS.
Inflation is the rate at which the general level of prices for goods and services is rising, and, subsequently, purchasing power is falling. Central banks attempt to stop severe inflation, along with severe deflation, in an attempt to keep the excessive growth of prices to a minimum.
Liquidity risk is the possibility that securities cannot be readily sold within seven days at approximately the price at which a fund has valued them.
Additional Tier 1 (AT1) Bonds serve as capital instruments that banks utilize to augment their core equity base. Unlike conventional bonds, AT1 Bonds are perpetual and thus, the investors are not paid the principal amount.
Duration measures a bond’s sensitivity to interest rates, by indicating the approximate percentage of change in a bond or bond fund’s price given a 1% change in interest rates.
Inflation is the rate at which the general level of prices for goods and services is rising, and, subsequently, purchasing power is falling. Central banks attempt to stop severe inflation, along with severe deflation, in an attempt to keep the excessive growth of prices to a minimum.
A Treasury yield refers to the effective yearly interest rate the US government pays on money it borrows to raise capital through selling Treasury bonds, also referred to as Treasury notes or Treasury bills depending on maturity length.
The yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates. The most frequently reported yield curve compares the 3-month, 2-year, 5-year, and 30-year US Treasury debt. This yield curve is used as a benchmark for other debt in the market, such as mortgage rates or bank lending rates. It is also used to predict changes in economic output and growth.
The shape of the yield curve is closely scrutinized because it helps to give an idea of future interest rate change and economic activity. There are three main types of yield curve shapes: normal, inverted and flat (or humped). A normal yield curve is one in which longer maturity bonds have a higher yield compared to shorter-term bonds due to the risks associated with time. An inverted yield curve is one in which the shorter-term yields are higher than the longer-term yields, which can be a sign of upcoming recession. A flat (or humped) yield curve is one in which the shorter- and longer-term yields are very close to each other, which is also a predictor of an economic transition. The slope of the yield curve is also seen as important: the greater the slope, the greater the gap between short- and long-term rates.
Yield curve inversion is when coupon payments on shorter-term Treasury bonds exceed the interest paid on longer-term bonds.
Economic trend information is sourced from Bloomberg unless otherwise noted.
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