What’s Keeping us, fixed income PM’s, Up at Night…

Several factors in the macroeconomic environment are in the investor's sights at the start of the year, namely:

1. Geopolitical tensions continue to escalate in the Middle East. Iran-backed Houthi rebels attacked ships traveling through the Red Sea during December. Meanwhile, Iran deployed a warship to the Red Sea in early January, a move intended to challenge US forces in the key trade route and one which may embolden the Houthi militants that have disrupted shipping in the waterway to protest Israel’s invasion of Gaza. As the Red Sea constitutes a chokepoint in maritime trade, several shipping companies have paused or diverted cargo routes to circumnavigate Africa instead. This is causing shipping times and costs to increase, though we remain far from extreme pricing seen in 2021-2022.
2. Unexpected reacceleration. The extent of the rally in the last two months of 2023 makes one wonder whether the market may have gone on auto-pilot and gotten ahead of itself by pricing in a soft landing/goldilocks outcome with aggressive rate cuts to start as early as the spring. Early trading in January suggests investors are expecting a very narrow set of outcomes, which could be derailed by upward surprises in the economic cycle, such as continued consumer resilience, strong labour markets and loosening financial conditions. While disinflation is likely to continue, we find ourselves in an uncertain environment and bond exuberance can suddenly shift to nervousness should we not see a return to the 2% inflation target.
3. Quantitative tightening, and the debate around its ending, is likely to be a hot topic in the months ahead. While Chair Powell had previously indicated QT could continue after rate cuts, there has been speculation on whether QT should in fact end before cuts are initiated to ensure stability in the financial system by not depriving market participants of reserves along the way. This debate is hotly discussed within Wellington between our macro strategy and banking research teams. The pivot to policy accommodation coincident with potentially reaccelerating growth proves to us we really have entered an uncomfortable and less predictable, though by no means less exciting, market regime.
4. Elections and their impact on markets. 2024 is set to be a record year, with over 2bn people heading to the polls in the next twelve months. Mexico and India have elections in the second quarter, and the European Parliament vote will take place across its 27 countries in early June. The US and UK hold elections in the same year for the first time since 1992. The run-up and outcome of the former will be hotly contested, while the latter appears all-but-certain to end 13 years of Conservative party rule. These elections will put on display the resilience (or lack thereof) of democratic institutions across the world, but will also test financial markets in general and bond markets in particular. Political parties of all stripes, and especially anti-establishment outfits, are showing little commitment to fiscal prudence with significant spending commitments likely to impact term premia.

Sectors in which we see opportunity (as an active manager, our views/positioning are dynamic and the below may not change for months or may change intra-month depending on market conditions):

• Given how drawn out and uncertain the rate cycle has been this year, we move up to our top recommendation higher quality total return strategies that are less constrained by benchmarks. This could include global sovereign and currency strategies that shine during these periods or unconstrained strategies that have the ability to navigate the late cycle by allocating across different sectors.

• Core fixed income, and particularly Credit, strategies are looking increasingly attractive. Higher quality fixed income is attractive from both an income and capital protection perspective, providing a combination of carry, substantial cushion for potential (though now very unlikely) rate rises and significant upside in a risk-off environment. Carry on such strategies has only grown more attractive, providing additional buffers to rate volatility. 

• European investors looking to protect themselves from ongoing volatility and uncertainty can earn attractive income in high quality bonds, both in local indices but also by going global.

• Allocating to cash may be short-sighted. We have seen significant flows into cash and cash-like products over the last 18 months, and while earning a healthy yield in an uncertain environment sounds appealing, the opportunity cost of not putting this cash to work in fixed income is growing. Yields on high quality bonds mean the income stream is similar to cash, while also embedding downside protection, should central banks deliver on rate cuts in 2024. For investors concerned about timing their allocation out of cash into fixed income, historically it has paid off to be early relative to the last hike, rather than late. 

• High yield and EM both remain attractive from an outright yield-to-worst perspective, but we expect continued volatility along with geopolitical risk. While fundamentals may worsen as lagged policy effects work their way through the bottom-up economy, corporate earnings have remained resilient so far. Notably, in Europe we are not seeing the same leverage build up in HY as we saw in previous cycles. While the market has grown by a cumulative 8% in the last 5 years, in line with GDP, while the private credit market has doubled in size over the same period.