Given current yield levels, slowing growth, and continued disinflation, fixed income moves into the limelight, offering attractive prospects for investors.
As we look towards 2024 and the prospect of a significant slowdown in economic activity, we believe sovereign fixed income — and US Treasuries in particular — offers investors an increasingly attractive proposition over the medium term. As with several other asset classes, we expect recent choppiness to continue. The seemingly unrelenting strength of the US labor market, and its implications for Federal Reserve Board (Fed) policy, has been, and may well continue to be, a source of angst. Meanwhile, favorable tailwinds are coalescing as the slowdown and the anchor of long-term demographics start to take hold.
Most major central banks have ratcheted up policy rates at the most aggressive pace in decades. The transmission of such an aggressive policy response, however, is notoriously long and variable in nature. We can therefore expect that the most recent rate hikes have yet to take their toll on an economy already facing an inevitable slowdown. Concurrent with this is a disinflation dynamic that still has a bit further to run. This policy-driven cycle favors an overweight duration position in sovereign debt, as lower rates and a bullish steepening are ultimately priced in. We believe that the US Treasury market offers the cleanest way of capturing this move in market pricing. In addition to the cyclical element, the longer-term demographic trend is also supportive of our bullishness on bonds. Muted labor force and productivity growth, as reflected in the US experience in Figure 1, underscore the fundamental long-term value in real yields across major sovereign debt markets.
Outside the United States, this may play out slightly differently. For example, across the major markets in Europe, core inflation remains high or has shown signs of being sticky; there is the added headache of higher energy costs likely feeding through into headline inflation. A stronger US dollar further compounds the issue. While the market may move to discount rate cuts sooner than currently implied and perhaps more aggressively than central bank rhetoric might suggest, there is still a risk that inflation becomes more entrenched and that eurozone and other European sovereign debt investors remain on the sidelines until they can envisage a more decisive move in the disinflation dynamic.
The other side of the aggressive monetary policy response is that European investors have a compelling alternative if they remain cautious on duration in the near term. The dramatic rise in short-dated bond yields suggests that the risk-reward profile (yield per year of duration) across several European markets is at its most attractive level in a decade or more (see Figure 2).
Although investment grade corporate credit has benefited from relatively solid fundamentals, we expect them to soften in the coming quarters as revenue growth fades in a slowing economy and margin pressures challenge bottom-line growth. Against that background, spreads — slightly below the average level seen over the past 20 years — do not look inviting. A further point of caution arises in relation to the declining quality of the overall investment universe in US dollar, sterling, and euro corporate credit. A selective approach is persuasive, but at current spread levels, we feel investors can afford to wait for better entry levels.
Absolute yields (broad benchmark level) for sub-investment-grade debt have risen substantially in recent quarters in line with the trend across debt markets in general. This pattern is not an immediate problem given the modest near-term refinancing needs, but it does raise the specter of borrowers having to issue debt at significantly higher coupons if yields are still elevated at the point of refinancing. Euro-denominated debt, in particular, faces substantial refinancing needs two to three years out. Consequently, the longer yields stay at these relatively high levels, the greater the risk of meaningfully higher refinancing costs for issuers.
Similar to its investment grade counterpart, high yield debt has been trading at relatively compressed spreads. Default rates are currently quite modest but can only rise as our predicted slowdown bites in 2024. In that environment, we anticipate a rise in distress ratios and in average index-level spreads. Consequently, we do not consider high yield debt a compelling proposition at current spreads.
Against a backdrop of heightened volatility and uncertainty, hard currency emerging market sovereign debt currently looks attractive in light of the spreads on offer. With spreads in the high yield subsegment trading well above their long-term average, markets have already priced in most credit events (see Figure 3). Credit quality has shifted as the credit rating composition of indexes has changed. In high yield, the proportion of the lowest-rated credits has increased as countries have defaulted, restructured their debt, and been downgraded. In investment grade, in contrast, the proportion of the highest-rated credits has grown largely due to the addition of highly-rated Gulf countries that have been large issuers of debt, resulting in a quality upgrade. Moreover, in the absence of a US recession, spreads have the potential to tighten further. There is also additional upside possible from a rally in Treasuries when the data does turn and the market starts to price in a dovish Fed pivot.
On the other hand, the picture for emerging market local currency debt (EMD LC) has become a lot more complex. Firstly, emerging market monetary policy has decoupled from the Fed, so the differential between the yield on EMD LC and US Treasuries is around the lowest it has been in 15 years. Next, the strong US dollar is clouding the short-term outlook — not only because of its direct impact on emerging market currency returns, but also indirectly because of its impact on emerging market inflation. However, real yields have now turned positive for some of the largest constituents in the broader EMD LC Index, and even though this is still below US Treasuries, it offers a pick-up versus the euro area.
As the impressive resilience of the US economy fades in 2024, we believe that sovereign fixed income offers investors a rewarding opportunity. The US Treasury market is probably best placed to capture this prospect. The short end of several sovereign debt markets also presents a compelling yield-duration profile for those investors unwilling to embrace duration more fully. A slowing economy and advancing credit cycle will present challenges to corporate income and balance sheets. Therefore, we expect that there will be more rewarding entry levels for credit investors in the coming quarters. There are attractive spread opportunities in hard currency emerging market debt, assuming a hard landing is avoided. The picture for local currency emerging market debt is more nuanced but still offers attractive pick-up potential for eurozone investors.