Adjusting interest-rate-cut expectations
The unprecedented fiscal spending to support economies during the pandemic resulted in a surge in inflation. Bond markets suffered, as central banks then raised interest rates at high speed in response to this inflation. Although there has been much talk about rate cuts so far this year, interest rates are set to stay higher for longer, as the US economy has been more resilient than expected in the first half of this year. Market expectations regarding rate cuts in 2024 have changed accordingly – expectations of up to seven rate cuts by the US Federal Reserve in January have come down to just one or two now. We believe that rates will eventually come down, even if not to the extent that many had initially anticipated.
US government debt: What happens now?
Another topic that is well and truly back in the spotlight is the size of the US government’s debt. With the high debt levels incurred over the last decade, the question is now: if the government continues to run substantial debt-financed deficits while the US Federal Reserve buys a smaller amount of bonds, where will the demand for US government bonds come from?
We therefore believe that we are in a ‘price-finding’ period for US Treasuries as the yield levels adjust accordingly, depending on demand. The US presidential election, taking place in November this year, adds to the uncertainty, as it is unclear if and how the winner of the election plans to bring down the deficit. We therefore advocate investments in quality corporate bonds rather than government bonds. We suggest focusing on the higher quality portion of the segment, as these bonds are much less prone to solvency issues.
Opportunities in Europe
In Europe, where inflation is declining and the economy is struggling, we see few reasons why the European Central Bank should hold back with its rate-cutting cycle, and this should create a more bond-friendly environment. As in the US, in Europe we suggest focusing on quality corporate bonds. Moreover, eurozone periphery sovereigns should benefit from an improving cyclical picture.
Emerging market hard-currency debt
For more risk-friendly investors seeking higher yields, emerging market hard-currency debt is our preferred segment in the fixed income space. We advocate selective exposure and would focus on Asian investment-grade bonds due to their attractive valuation levels, Latin American bonds due to the positive growth outlook there, and Middle Eastern bonds because of the sticky oil prices.
A balanced duration approach
In terms of fixed income positioning, we think that the key at the moment is taking a balanced duration approach, whereby we mean having exposure to bonds of different maturities along the curve. The US yield curve is currently still inverted, i.e. yields at the short end are higher than at the long end. We believe that it makes sense to have some exposure to short-dated bonds in order to take advantage of the attractive yields. Then when these bonds mature in the not-too-distant future and these funds become available to reinvest, yields could be considerably lower. In our view, this justifies also having some exposure to longer dated bonds, where although the yield is currently lower than for shorter-dated bonds, investors nevertheless benefit from locking in these historically high yields for a longer period of time.In addition, we suggest managing the duration exposure and becoming active when yields move, which means bond investors will need to become more agile and move away from the buy-and-hold patterns of previous decades.
