Deep dive into fixed income markets

[Management Team] [Author] Thozet Kevin
Author(s)
Published on
4 November 2024
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1 minute(s) read

The macroeconomic climate

After 2023, which saw a return to positive performance across the fixed income spectrum, in 2024 the level of performance has followed the same trend. The returns on core countries’ government bonds on both sides of the Atlantic have been less than the carry – although these markets have regained some of their diversification attributes (i.e. they performed well when needed most, at times of market stress). The returns in credit markets – as measured by indices – have broadly equalled the carry embedded at the beginning of the year. The main outlier has been emerging market (EM) local debt, which has returned less than cash this year despite posting close to double-digit yields at the beginning of the year.

YTD performance of the main bond indices (at 23/10/2024)

US Treasuries (10-year)+1.19%4.25%+37 bps
Germany (10-year)-0.08%2.30%+28 bps
EUR Credit Investment Grade +3.93%103 bps-32 bps
EUR Credit High Yield+7.29%325 bps-70 bps
EM Sovereign Debt Hard Currency (USD)+5.79%344 bps-40 bps
EM Sovereign Debt Local (USD)+0.16%6.39%+20 bps
Source: Bloomberg, 23/10/2024.

In terms of the economic trajectory, we’re still on track for a soft landing of the global economy, with GDP growth expected to stabilise at around 2.5% over the coming months thanks to the resilience of the US consumer and a synchronised cycle of rate cuts.

This stabilisation will be further supported by ongoing disinflation in both the United States and globally, which has finally culminated in a long-awaited, synchronised easing cycle.

In addition, the Chinese government is opening the door to overdue monetary and fiscal stimulus thus moving in the right direction. There are increasing signs that Beijing is adding a “fiscal put” to its “monetary put”. Concretely speaking, the Chinese government is finally taking the bull by the horns – which could also have positive spillover effects on other emerging markets and Europe.

This will provide welcome support, given that Brussels’ rules-induced austerity will impair economic growth, notably for France and Italy. And the heavy lifting done by the European Central Bank in lowering its policy rate to around 2% won’t be enough to provide for a sustained rebound of the economy.

A dovish central banks reaction, China’s fiscal put, and falling eurozone inflation are all putting a floor under the deceleration in global growth.

Review of fixed income asset classes

Below we give an in-depth view of each asset class in the fixed income universe:

The global and increasingly synchronised monetary easing cycle is gaining momentum. Fixed income markets expect policy rates in the eurozone to fall back to close to 2.0% in the coming year, while long-term core sovereign bond yields currently stand at 2.25%. In the United States, policy rates are expected to land a touch below 3.5%, while the 10-year Treasury yield is hovering a mere 0.7% higher, at 4.2%.

This climate calls for some degree of caution on long-term sovereign bonds. There’s still a large supply of these bonds, and central banks are proactively cutting rates to avoid damaging their economies. Since quantitative tightening is still taking place (thus further reducing the demand for bonds), there’s a risk of upward pressure on sovereign yields. Besides, some amount of inflation premium seems warranted, as central banks are lowering their policy rates even though inflation hasn’t yet come back to the 2% target.

In contrast, shorter-term sovereign bonds appear more attractive. Should fears of a more serious economic slowdown resurface, the markets would price in a more aggressive cutting cycle, which would lower short-term yields. This central bank “put” on cyclical risk is one reason why we prefer corporate credit and emerging markets in the risk asset space.

In the United States, we believe the government bond yield curve will continue to steepen, even more given the outcome of the US elections. In the eurozone, the acceleration in disinflation – which has finally led to headline inflation readings below the 2% threshold – and the Brussels-imposed fiscal austerity measures in Italy and France are penalising GDP growth. This should lead to lower core bond yields across the curve.

Regarding developed market government bonds, investors have been reminded that these markets are not just a rates story but that spreads matter, too. Concerns over widening fiscal deficits, notably in France, have been brought into broad daylight. We therefore suggest caution on eurozone government spreads across the board – and especially in France.

Credit markets are providing an antidote to the government yield curve configuration described above. The credit spread curve is positively sloped across the maturity spectrum, giving investors a way to mitigate the negative slope in government bonds and making the yield curve for corporate bonds much more attractive.

Technical factors are also supportive. Flows into this asset class have been massive, especially in strategies that are less sensitive to mark-to-market (e.g. target maturity funds) and where assets therefore tend to be less volatile. Issuances have slowed, yet remain firm. The number of rising stars is positive for the fourth year in a row.

Finally (and most importantly), fundamentals also appear to be better oriented. Economic growth is showing signs that it may well have bottomed out, given that both the Federal Reserve put and Chinese put are back. The expected falling cost of capital and looser lending standards suggest that default rates will stabilise (in the area of 4%). In addition, the bottoming out of economic growth also points to a more benign environment on the earnings front.

As a result, we’re positive on credit and on the fundamentals, owing in part to the carry (which ranges from 3.5% to 6.4% across euro-denominated segments). The main drawback relates to valuation levels; credit spreads appear relatively tight by historical standards.

We believe that local EM debt still offers very attractive risk-adjusted yields in the global sovereign debt segment. Local EM debt should benefit from an attractive carry – 6.4% at the index level – and from the potential for bond price appreciation as the Federal Reserve begins its cutting cycle, which should enable EM central banks to cut rates more aggressively than what’s currently priced in.

We believe real interest rates are too high in these economies, where disinflation is more advanced than in the developed world.

EM issuers offer attractive investment themes in the current environment and provide valuable decorrelation since local EM debt tends to move independently of risk-on/risk-off narratives (contrary to hard-currency debt and foreign exchange markets).

Yet careful selection will be key. In over 60% of EM countries, inflation is still above the central bank’s target or target range. The central banks of countries such as Brazil and Mexico have plenty of leeway to support economic growth if the outlook darkens, since real interest rates there are currently in the 5% to 6% range.

Inflation expectations have been trending lower on the back of ongoing disinflation. 10-year eurozone inflation expectations have even fallen below the 2% threshold for the first time since the spike two years ago. This (among other factors) has led to the first interest rate cuts by all but one G7 central banks.

However, by cutting rates now, while inflationary pressure remains present in several parts of the economy, aren’t central banks sowing the seeds of future inflation?

The Federal Reserve is cutting rates and has signalled it’s embarking on an easing cycle, even though indicators show that US GDP growth is running at more than 3% – i.e. well above its potential. China appears willing to stimulate its economy more drastically, which finally also includes traditional, proper cyclical stimulus. And whether in terms of tariffs or strikes, there’s a whiff of the late 1970s in the air.

In this climate, we prefer real rates to nominal rates – i.e. we favour inflation-linked bonds over nominal bonds as well as inflation break-even widening strategies.

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