Alex Rohner, Fixed Income Strategist at J Safra Sarasin Sustainable Asset Management shares his outlook for fixed income in 2024 and cites six good reasons behind why he and his team are favouring Investment Grade over High Yield bonds.
We retain a positive outlook for fixed income for 2024. Valuations are attractive, central banks’ monetary stance is already tight and we expect the economic outlook to be very soft at best. We believe that the current pricing for policy rates over the coming years is too elevated and see downside to rate expectations and lower bond yields over the next 6 to 12 months. Within the credit space, we retain our preference for Investment Grade over High Yield.
We would highlight the following points as to why:
The monetary policy stance is tight
The monetary stance of developed markets’ central banks is likely already tight. The US is a case in point: US 10- year real yields, as measured by the inflation-linked market, are at their highest level relative to the Fed’s estimate of the real neutral interest rate since 2008. Sharply tightening lending standards, much weaker credit creation and rising delinquency rates on consumer and car loans clearly support the notion that the monetary stance is starting to bite more decisively in the US.
The full effects of monetary tightening are yet to be felt
The US economy has proven, so far, much more resilient to higher rates than anticipated. Nevertheless, we expect the cumulative effects of tighter policy to become more evident in the US over coming quarters as fiscal support could turn into a drag next year. In the euro area and the UK, where fiscal support has been less prominent in 2023, the impact of tighter policy is already much more visible. As inflation moves lower over coming quarters, the monetary stance should become increasingly tighter if rates were to stay up. Increasingly, the market’s focus will shift from inflation to concerns about the negative effects of higher rates on the real economy.
Sharply higher starting yields provide better expected returns and a substantial cushion against adverse yield moves
The sharp repricing in developed markets (DM) rates structures has led to the highest yields to maturity in 15 years. For fixed income investors, this should be very welcome news. Not only will the substantially higher starting yields provide higher returns, both in the short term and in the long term, but they also provide a more meaningful cushion against adverse yield moves.
Higher real rates are a headwind for risk assets
Credit spreads of Investment Grade (IG) and High Yield bonds both trade below historical medians. This implies that spreads do not reflect the risk of a substantial economic slowdown, let alone a recession. As an example, consensus expectations are looking for default rates of around 4.5% both in 2024 and in 2025, a sharp increase from 2022 and 2023. Sharp rises in default rates have usually
been accompanied by a more meaningful widening in spreads. The recent rapid increase in long-term real government bond yields will likely tighten financial conditions further, raising the risk of more pronounced economic weakness than markets currently anticipate. Therefore, we retain our preference for IG over High Yield and would generally stick to higher quality.
Euro area – a prolonged period of very weak growth
The ECB has hiked its policy rate by 450bp to 4% over the past 15 months, higher than in 2000 and 2008. The sharply higher interest rates are meaningfully impacting the credit channel and dampening demand. The structural labour shortage helps explain why the unemployment rate has trended lower over the past year and should prevent unemployment from rising sharply. In addition, the fall in headline inflation and hence positive real wage growth should support consumption somewhat next year, such that we could see a prolonged period of very weak growth rather than a more abrupt period of economic contraction. Forward markets currently price the ECB policy rate to reach a cyclical low of 2.75%, substantially above our estimate of neutral. Hence we see some downside to policy rate expectations in 2024 and lower bond yields. Besides weak growth, markets should increasingly shift their focus on the effects of higher interest rates on debt sustainability. As pension, defence and infrastructure spending will need to increase as well, fiscal sustainability is likely to become more challenging for some highly indebted countries.
UK – the Bank of England is likely done
The Bank of England (BoE) has hiked its policy rate by 515bp to 5.25% over the past 24 months, the highest level since 2008. The cumulative effects of monetary tightening can already be felt, in particular in the real estate market. Real economic growth has ground to a halt, with inflation still too elevated. The so-far tight UK labour market is showing clear signs of loosening up, implying increasing headwinds also to private consumption. Moreover, the BoE estimates that only about half of the impact of the cumulative tightening on GDP has been felt so far. Therefore, we believe that the BoE is likely done hiking rates. Forward markets still price the BoE policy rate not to fall below 4% in this cycle, that is, no material economic weakness, let alone a recession. We feel that there is room for markets to price more policy rate cuts, and hence lower bond yields over the next 6 to 12 months.
