09 Jan 2024
Jonathan Platt, Head of Fixed Income
Markets are feeling more normal, after the holiday lull. The major economic focus was last Friday’s jobs data, where the headline showed an above consensus gain in non-farm payrolls and stronger than expected average hourly earnings.
This reinforced the push-back, seen in recent days, to the interest rate cuts and soft landing scenario that supported financial markets pre-Christmas. Looking at the change over the last two weeks, the market is now pricing a Fed Funds rate of around 4% in 12 months’ time, a rise of 25bps from previous levels. The picture is similar in the euro area and the UK; rate cut expectations are now being pared back although still showing material reductions through the year. This has been reflected across yield curves. In the US, yields are between 15-20bps higher over two weeks whilst the UK has seen 10-year rates move from 3.5% to 3.8% and German 10-year yields finished the week just shy of 2.2% after hitting a low of 1.9% in late December.
Central banks will be happy with some moderation in rate expectations – after all they have been trying to talk down bullish sentiment for some time. Looking at the data, however, and there was something in it for the growth pessimist. Job gains in the preceding two months were revised down and the December rise was helped by strong growth in government recruitment. The unemployment rate remained unchanged at 3.7%, courtesy of a smaller labour force, but masked a meaningful decline in the household survey measure of employment.
Credit yields mirrored the move in government markets. Heavy supply of euro and US dollar bonds has begun to weigh on spreads; the impact on sterling has been more muted but spreads are off their December lows by 8bps.
So, time to put cards on the table. Where are we positioned? What outlook does this reflect? And what could go wrong? In government markets, duration is below benchmark; Craig Inches and our Rates & Cash team think expectations have got ahead of reality. We are cautious on European markets, are more neutral on the UK and like Australian and US bonds. Global real yields have moved down a lot in recent weeks. In the UK 20-year index linked gilt yields hit 1.6% in October, touched 0.8% in December and are currently around 1.1%. Whilst the Debt Management Office (DMO) has cut back on index linked gilt issuance, the heavy supply schedule of nominal bonds may put upward pressure on real yields. As we still think that long-dated ‘breakeven’ inflation is richly priced, there is better value in US TIPS. In addition, don’t forget the role of cash in asset allocation; cash and short-term fixed income strategies offer attractive yields with minimal duration risk.
On credit, the preference remains for investment grade. Sterling spreads contracted last year, reaching a December low of 1.1% for non-gilt indices; we are now back nearer 1.2%. The consensus seems to be that the present valuation remains expensive. This is where a reality check is useful. The main concern of credit investors should be default – whether they receive their contracted cashflows on time. But credit investors are consistently over-rewarded for taking such risk. Historically, only about a third of the current sterling spread is required compensation for default risk. The rest can be put down to liquidity and credit rating migration risk. That looks like quite a bit of excess yield for non-default factors. That is not to say that credit spreads cannot go wider and I do think that heavy supply will put pressure on valuations in Q1 but, over the medium term, we believe that investment grade credit remains appealing. From a duration viewpoint, short-dated strategies look interesting with lower duration, more transparent credit risk and attractive spreads.
The outlook in high yield is more mixed. The preference remains for short-dated strategies, especially where re-financing risk is low. The wider picture is more cloudy; overall yields have fallen a lot through lower government rates and tighter spreads. The view from Azhar Hussain and his Global Credit team is that more caution is required on all maturity approaches and that spreads could back up, following the strong run into year end.
So, what does our positioning reflect in terms of economic and market outlook? More of the same: sluggish growth, some further disinflation and heavy government issuance. Not goldilocks but not a global recession either. We think that rates will come down, but not as fast as presently priced into curves and inflation, although lower, will not return to the levels seen through most of this century.
And what could go wrong? For one, geopolitics are uncertain. The situation in the Middle East could deteriorate further, with implications for commodity prices and business confidence. The war in Ukraine may worsen or could see a resolution that is unfavourable – an outcome that could embolden China’s approach towards Taiwan. With a pivotal US presidential election this year we could see more volatility in US policy – especially if Donald Trump is elected – as well as changes in the UK if, as polls suggest, we see an end to 14 years of Conservative led governments.
Strategies need to remain flexible enough to adapt to change and there will be shocks this year. In the words of a former heavyweight boxing champion: "Everyone has a plan till they get punched in the mouth."
This is a financial promotion and is not investment advice. Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.