THIS time last year, the US Federal Reserve and its chairman Jerome Powell were attempting what nearly everyone agreed was impossible: bring down inflation without anything bursting.
Yet, even as the Fed hiked interest rates faster than any time in recent memory, the US economy remained strong and inflation cooled. Contrary to all expectations, higher rates have brought sanity to the market, not a bloodbath. For fixed-income investors, that’s a very good thing.
Barring unforeseen events, it looks as if 2024 will finally end a dark era for global bond investors and the world economy – a regime led by zero and even negative interest rate policies that forced investors and savers to take on uncomfortable amounts of risk. History will not look back favourably at this period and the many unintended consequences such policies brought.
The new regime, with rates higher but likely not rising any further, presents something of a Goldilocks scenario for fixed income. Finally, “yield is destiny”. In other words, while we can always expect periods of volatility, long-term fixed-income investors should see elevated yields manifest as elevated returns, with little to fear from interest-rate risk eating away at their positions.
How should investors think about repositioning themselves for a big year in the fixed-income market?
One could say a big year for bonds has already happened in the last two months of 2023. Leveraged loans, investment-grade and corporates and high-yield issues – which at times last year were great value – look less attractive now, as much of the juice has already been squeezed out. But despite the rally, attractive values can still be had in a number of areas, with yield characteristics quite attractive overall. That’s where individual security selection matters.
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The commercial mortgage-backed securities (CMBS) market has been tainted by concerns around commercial real estate since the pandemic broke out. But ever since the global financial crisis, CMBS structures have tightened, with subordination reducing credit risk and providing investors with a quicker path to being repaid in the event of defaults.
While worries persist about the immediate future of office space in a world where many more people are working from home, the asset class is trading at an attractive discount and the worst predictions of lasting damage to the commercial market seem overblown. In general, there’s value in high-quality structured products.
Financials are another area that stand to benefit from stable or falling rates in this new regime. While there was much hand wringing about the health of the banking system – especially regional banks – after Silicon Valley Bank’s collapse in March 2023, deposit outflows have since stabilised.
Banks have been able to rebuild capital, and should soon see increased stability with Basel III Endgame, a new set of banking regulations, on the horizon. These new regulations would increase capital buffers for the biggest banks in the banking system and guard against the issues that caused the collapse of the US regionals.
There are also significant tailwinds for emerging markets (EM), which were first to raise rates in response to inflation and will likely be the first to cut. Favourable developments for EM include fierce competition between the US and China for hegemony in the global south; the movement of supply chains out of China and growing foreign direct investment in other EMs; and the rising demand for commodities like lithium and copper to build out new technologies and green infrastructure.
With inflation in EM countries falling faster than developed markets, the beginning of a rate-cutting cycle would greatly benefit EM growth as real rates remain positive. Of course, not all emerging markets are the same. Investors should look at countries such as Indonesia, India and Mexico that are growing rapidly and benefitting directly from the shift in supply chains.
Investors in European bonds may have more time to adjust to a new regime. Recently, European Central Bank president Christine Lagarde indicated Europe could see rate cuts in the summer. Europe will likely remain patient for lower inflation numbers and less buoyant profit margins. However, our base case assumes rates will be cut by 50 basis points by Q4 2024.
How much staying power this new regime of higher rates will have will be determined by the stickiness of inflation. Investors should watch the US labour market, where upward pressure on wages, particularly in the services sector, continues to be buoyed by low unemployment rates even as labour demand has eased. Geopolitical headwinds, such as the threat to shipping lanes in the Middle East and the war in Ukraine, may strain supply chains and further elevate prices. These factors will likely keep the Fed from a dovish turn in the near term.
While a recession could necessitate rate cuts sooner than expected, we place the odds of a US recession at only 25 per cent. Self-inflicted wounds, however, such as a federal government shutdown, may change that calculus. Historically, for each week that the government is closed, current quarter real GDP contracts by 20 basis points on average.
In the big picture, however, rates hitting a plateau is the ideal time to invest in bonds. Once the Fed and central banks across the globe start cutting rates, we should expect to see even more investors pare back on stocks and cash holdings, and return to more traditional portfolio allocations, which means a massive shift into bonds, and a subsequent fall in yields. Investors who fail to lock in higher rates now may end up losing out in the long run.
The writer is co-chief investment officer, PGIM Fixed Income
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