Jim Cielinski, Global Head of Fixed Income at Janus Henderson Investors, recognises markets were impatient in wanting rate cuts but the offset is fresh opportunities for investors to capture attractive yields.
There is a renowned joke about a lost tourist in Ireland who asks one of the locals for directions to Dublin. The local farmer frowns and replies, “Well, Sir, I wouldn’t start from here, if I were you.” Fixed income investors a few years ago would have sympathised. Yields were near all-time lows and vulnerable to upward moves, and bonds were offering little in the way of income. Today’s fixed income market looks very different. Yields are at levels that typically pay well above inflation and offer the prospect of capital gains if rates decline. For those seeking attractive returns, you can start from here. We see strong prospects for both healthy income and some additional capital appreciation in the next six months.
False starts but easing is underway
Fixed income markets have been fixated on the timing of interest rate cuts. This requires not just a focus on economic and inflation data, but on the policymakers themselves. No one is looking to central banks for their forecasting acumen, which has been deplorable. Markets look to central banks because they set policy. In a clear admission of their lack of clairvoyance, they have become highly “data-dependent” and reactionary. The issue is that the key metrics they fixate on – inflation and employment – are lagging indicators. This is compounded by the fact that their policy tools also work with a lagged effect. Sticky inflation has led to markets pricing out expected rate cuts, with the US Federal Reserve (Fed) forecast to do one or two rate cuts this year, down from six to seven at the beginning of the year.1 This approach is a recipe for a policy mistake if inflation does not behave over the coming months.
The corollary of delayed rate cuts is that it has extended the opportunity for fixed income investors to lock in some attractive yields. Investors are being paid to wait for rate cuts to emerge.
Figure 1: Income yields are well above inflation
Source: Bloomberg, inflation rates, year on-year % change at 30 April 2024: US Consumer Price Index for All Urban Consumers All-Items, Eurozone Harmonised Index of Consumer Prices. Yields as at 31 May 2024 in chronological order: 3-month US Treasury Bill, US 10-year Treasury Bond, ICE BofA US Corporate Index (yield to worst), ICE BofA US High Yield Index (yield to worst), ICE BofA US Mortgage Backed Securities Index, ICE BofA US ABS & Commercial MBS Index, Germany 3-month Bund, Germany 10-year Bund, ICE BofA Euro Corporate Index (yield to worst), ICE BofA Euro High Yield Index (yield to worst), Credit Suisse Western Europe Leveraged Loan Index. The yield to worst is the lowest yield a bond (index) can achieve provided the issuer(s) does not default; it takes into account special features such as call options (that give issuers the right to call back a bond at a specified date). Yields may vary over time and are not guaranteed.
Outside the US, a global rate cutting cycle is already underway. Rate cuts in emerging markets started in the second half of last year and have since gathered pace. In the developed world, the Swiss National Bank fired the starting gun on rate cuts in March 2024, followed by Sweden’s Riksbank in May and the Bank of Canada and the European Central Bank in June. The regime is shifting.
Is the decline in inflation stalling?
The hold-up in the US is due to inflation. Whether it is airline tickets or motor vehicle insurance or rents, there have been many reasons as to why the decline in inflation has stalled. In accounting, there comes a time when a company uses the ‘exceptional items’ term a little too often and investors grow sceptical of the strength of a company’s earnings. Should similar cynicism be applied to the Fed and its fight against inflation?
We think not. First, the stalling has occurred at the all-items level, which includes volatile food and energy prices. Core inflation remains on a downward trend. Second, inflation does not move in a straight line so we should expect the occasional volatility. Third, inflation data is notorious for lags and at current levels it is not too far off the Fed’s target. In fact, if the US reported inflation using the Harmonised Index of Consumer Prices measure (as is common in Europe) US inflation would be running at 2.4%.2 Moreover, inflation expectations among consumers remain well anchored at around 3% for the coming year in both the US and the Eurozone.3 Wage demands are also moderating in most economies. Research suggests that wage growth tends to be a symptom of inflation rather than causing it.4 The decline in inflation is therefore likely to underscore the trend down in wage demands. Patience may be required for a few more months, but the trend remains intact.
Figure 2: Inflation tends to lead wage growth (year-on-year % change)
Source: U.S Bureau of Economic Analysis, Personal Consumption Expenditure excluding food and energy (Core PCE), Wage growth is represented by Employment Cost Index (total compensation, all civilians), quarterly data, year-on-year % change, Q1 1982 to Q1 2024. Core PCE is the Fed’s preferred inflation measure. There is no guarantee that past trends will continue, or forecasts will be realised.
Doing nothing is still doing something
As the UEFA Euro 2024 soccer journey unfolds this summer, one is reminded of some research on goalkeepers and penalty shootouts. Goalkeepers have a tendency to dive in a particular direction to save a penalty (action tends to make the crowd more forgiving), when typically they would save more penalties if they simply stayed in the middle of the goal.5
Central bankers may think that if the economy is growing modestly, labour markets are healthy and inflation is contained, why not stay put? After all, central bankers have a greater reputational loss from allowing inflation to rise than they do from causing economic weakness or unemployment.
Yet, they are conscious that their policy also works with lags, so the longer rates are held at current levels, the more financing pressure builds. We have already seen problems exposed among regional banks last year and more recently among companies with excessive debt levels.
Sub-investment grade default rates have only risen modestly, however, and are expected to stay around the low mid-single digit mark of between 3-5% in Europe and the US for the remainder of this year. The reason defaults have been low is because investors have been willing to lend to companies. The technical backdrop of debt issuers finding ready buyers has been supportive but part of that rests on the expectation that rates will be lower in the coming year. This encourages investors to lock in yields on issued bonds now while they are relatively high, while taking comfort from the fact that lower rates in the future should be supportive for the economic and corporate backdrop.
Everything in moderation
Outside of a major growth surprise or inflation shock we struggle to see major central banks raising rates. The risk to rates markets therefore is that cuts are fewer and slower than expected. We therefore prefer European markets over the US where Europe’s relatively weaker economy offers more visibility of a lower rates trajectory.
For many fixed income assets, a slower rate-cutting path is not necessarily a bad thing if engendered by strong – but not too strong – economic growth, which is supportive for earnings and cash flows. With an economic backdrop of resilient, albeit moderating, growth in the US, a reviving European economy and less bearishness towards China’s economic outlook, there is the potential for credit spreads to grind tighter. Among corporate sectors we continue to prefer companies with good interest cover ratios and strong cash flow and see value opportunities in some of the areas that have been out of favour, such as pockets of real estate.
We recognise, however, that credit spreads in aggregate are near their historical tights, leaving little cushion should the corporate outlook take a turn for the worse. With that in mind, we see value in diversification, particularly towards securitised debt, such as mortgage-backed securities, asset backed securities and collateralised loan obligations. Here, misconceptions towards these asset classes, combined with a hangover from rates volatility, has meant spreads and yields on offer look compelling. Yields in the securitized sectors are more attractive on a historical basis, and more likely to stay out of trouble in a more severe slowdown.
The elephant in the room
It would be remiss not to mention politics, given the second half of the year will see the defining event of numerous elections, including one for a US president. This could shine a spotlight on government debt levels and fiscal profligacy – where France has become the latest sovereign bond issuer to suffer a downgrade.6 It could also reawaken concerns around protectionism and tariffs on trade, given that easing of supply chain bottlenecks has been instrumental in helping to bring down inflation from its post-COVID highs. Similarly, the conflicts in Ukraine and the Middle East could take unpredictable turns. Elevated political risk in the second half of 2024 should draw investors to assets that are traditionally lower risk, such as bonds, which offer some protection against a more pronounced slowdown or escalation in geopolitical risks.
In summary, the narrative of 2024 being a year of policy easing remains intact, even if some central banks have kept markets waiting. Rate cuts offer the potential for capital gains from fixed income but do not overlook the second word in the name of the asset class. Right now, there is plenty of income on offer.
