By Matthew Chaldecott – Senior Client Portfolio Manager – Fixed income – Invesco
Key takeaways
• We may be at a pivotal point for interest rates.
• Credit is offering the highest all-in yields for over a decade.
• While they won’t ring a bell for the bottom of the market, we think this is a decent entry point for the asset class.
The annual Economic Policy Symposium at Jackson Hole in Wyoming is always closely scrutinised, but perhaps more so this year as bond markets contemplate whether we are at a peak, plateau or progression in interest rates. Despite the old adage that they do not ring a bell at the top (or bottom) of the market, ears were nonetheless straining to hear one.
For the US, Federal Reserve Chairman Jay Powell came out a touch more hawkish than had been expected. While headline inflation has been coming down steadily in recent months, his speech focused more on the stickiness in the core Personal Consumption Expenditures Price Index (PCE), which remains at over 4%.
“Although inflation has moved down from its peak – a welcome development – it remains too high. We are prepared to raise rates further if appropriate, and intend to hold policy at a restrictive level until we are confident that inflation is moving sustainably down toward our objective.”
Meanwhile, ECB President Lagarde struck a robust tone. This was perhaps to be expected given the single mandate for price stability, and was borne out the higher-than-expected inflation numbers released on 31 August:
“In the current environment, this means – for the ECB – setting interest rates at sufficiently restrictive levels for as long as necessary to achieve a timely return of inflation to our 2% medium-term target.”
Bank of England Deputy Governor Ben Broadbent concurred with his counterparts, saying “it is likely that monetary policy will have to remain in restrictive territory for some time.”
While all three left enough ambiguity not to commit to any rate rises at the forthcoming meetings (the ECB did hike on 14th September, while the Fed and BoE held on the 20th and 21st respectively), the reasonable inference is that rate cuts are not on the horizon unless and until inflation data reach the 2% threshold and settle there.
This stands against market pricing, which is currently indicating that cuts could begin as soon as March in the US and UK, and January in the Eurozone.
What does this mean for credit?
Corporate credit spreads have rallied over the last year as several market concerns have been allayed. First, the world economy proved able to withstand an energy shock and sharp rate hikes. Then, the collapse of US regional banks and Credit Suisse turned out to be idiosyncratic rather than systemic.
On spreads alone, valuations are not as compelling as six or twelve months ago. Rather we are slightly inside the long-term median for US credit and somewhat outside for European credit. But this is reflective of a diminished risk environment and reasonable corporate fundamentals. Furthermore, from an all-in perspective, the picture looks more attractive.
Nominal yields for both US and European investment grade are at levels not seen for more than ten years (US Corporate at 6%, EUR Corporate at 4.5%, Sterling Corporate at 6.2%). More importantly, they are offering real rates of return after expected inflation – again at levels not seen since the Global Financial and Euro Crises.
They are also comfortably ahead of equity dividend yields – so our mantra from last year of Goodbye TINA (There Is No Alternative), Hello BERYL (Bonds Earning Real Yields – Lovely) remains valid. In other words, bonds are once again a viable option for investors as they look to meet their return goals.
Reflecting on what this environment means for pension schemes specifically, Ashar Muhammad drew attention to some changes in asset allocation trends. Ashar, a member of Invesco’s UK Pensions and Consultant Relations team, commented:
“The LDI crisis last year was a difficult time for most UK DB schemes, but they have generally come out of it with improved funding levels. As investment strategy reviews are underway, there are some broad asset allocation trends that we are already observing – a greater focus on liquidity, portfolio de-risking, and a better appreciation of the desired endgame. Going forward, we expect an increased allocation to fixed income, especially buy and maintain credit, which is ideally placed to meet the emerging needs of UK DB schemes”.
We expect yields to peak as monetary policy bites
Could yields continue higher? Of course, but probably only as the result of a deterioration in the corporate outlook, higher inflation, or a more aggressive central bank policy stance.
Our team’s base case, however, is inclined towards a topping out due to slowing inflation and growth as restrictive monetary policy bites. Softening forward-looking indicators such as the Purchasing Managers’ Indices (PMIs) seem to support this thesis.
We are overweight duration in our benchmark-aware accounts, particularly in the UK and front-end US. We also think that now is a decent entry point for a buy and maintain allocation, if you are an investor seeking to take advantage of those positive real returns for the longer term.
