2024: The year for Bond markets.
Last year we saw a massive spike in interest rates. Looking forward to 2024 we believe it may be a positive environment for fixed-income investors.

Using our analysis of the macro conditions and Fed intentions suggests that bonds will be a “Buy” for the year, thanks to the interest rate ceiling and evolving economic outlook. Recently, the Fed has indicated that they are on a pause and starting to discuss rate cuts with the dot plot showing 3 cuts in 2024 (-75bp) and an additional -125bp of cuts in 2025. Whilst the US is heading towards a rate-cut environment, cuts from the ECB may be further from this scenario. The risk is that inflation remains stubborn and could in turn increase, prompting a longer delay due to the markets already providing easier conditions; with 10-year US bond yields below 4% in December. However, the current environment means that investors (especially those managing books of assets and liabilities, such as insurance and pension companies) may look to secure the long-term real yields on offer currently –

10 Year - 1.97%
30 Year - 2.11%

(assumption is that inflation may hit 2%).

Currently, both the United States and Europe are in a cycle with low economic growth and a decrease in inflation. Consequently, interest rates are in their peak cycle. Forecasts indicate rate cuts for both economies in 2024. In the United States, these cuts could happen in the latter half of the year, signifying a positive opportunity to get good returns on short-maturity bonds. Contrastingly, in Europe, these rate reductions might happen earlier than initially projected due to the economy struggling, particularly the manufacturing sector. Therefore, it may be prudent to consider longer maturities in European bonds to mitigate the risks associated with reinvestment, considering the economy's continued challenges.

Where are we in the Global Macro Cycle?

An important consideration for any bond investor is an assessment of the Global Macro Cycle (shown below) and where we reside within such an environment. The consideration of where we are in any economic cycle is a fundamental basis of our overall investment analysis using our Macro, Valuations, Sentiment and Technical framework (“MVST”). Our analysis of this cycle shows that we have started to enter the phase where inflation is falling (from a high level) and growth (possibility of recession) overall is low with the central banks looking to maintain rates (or start cutting them). As such we consider this to be potentially the best moment for investments in bonds.

US Bond Market

In the current landscape, our MVST (Macro, Valuations, Sentiment and Technical) analysis framework is indicating a buy signal for bonds. The market is already pricing in a lower inflation rate, as the data presented continues to show during the last inflation releases. Projections also suggest a likelihood of rate cuts by the Fed in 2024, which is great news for the bond market and even for the stock market. Metrics like PMIs and new orders signalling contraction, both below 50, coupled with a forecast of below median economic growth, show weakness in the economy. However, it is not at the same level as Europe. Besides, amidst these challenges, the employment sector remains robust, providing a positive note. The overall stock market optimism during the year ended with a huge increase during November and December, which did diminish the allure of the bond market. This optimism might fuel further increases in the future.

Recent overall trends reveal a shift in investor behaviour with money flowing out of government bonds and into both high-yield (HY) and investment-grade (IG) corporate bonds. Notably, government bonds currently appear relatively expensive based on our analysis, potentially explaining the recent capital outflow. This shift toward corporate bonds mirrors the quest for better investment opportunities in the face of government bond overvaluation.

European Bond Market

The European Central Bank (ECB) is not inclined towards altering its strategy or reducing its balance. Yet, it's widely acknowledged that this stance might change in time. Meanwhile, short and medium-term bonds remain attractive as they offer good returns. For instance, the one-year German bond surpasses 3 per cent, outstripping the inflation rate and sustaining an inverted yield curve. Nonetheless, contemplating a shift in investment durations, particularly towards the middle and long segments of the curve, could be advisable. As the anticipated date for rate reductions draws nearer, the strategy of changing maturities to longer maturities allows for price appreciation of the bonds throughout 2024 and 2025. Persisting with investments in the shortest curve sections, amidst declining rates heightens the risk of reinvestment, making it difficult to replicate current returns on maturity.

While short and middle-yield curve segments present attractive yields due to historic highs and an inverted yield curve, transitioning towards longer durations seems prudent for long-term investors. This strategic shift anticipates sustained impending rate reductions and reduces reinvestment risks for investors.
Bonds have performed well around Fed pauses.

Empirical evidence shows that upon the Fed ending their hiking cycle, any pause encountered before a cut usually lasts less than a year. This firmly puts us in contention for a cutting cycle to emerge in 2024. Interestingly, bonds tend to rise even without a rate cut. Historical patterns indicate that when the Federal Reserve reaches the peak of its rate-hiking cycle, the following period typically sees exceptional overall bond performance.

Percentage of returns after the interest rate peak:

As we're not immune to entering a recession, it's important to highlight that historically, during economic downturns, there have been instances of positive yields for Treasuries and generally for highly rated investment-grade bonds. The next table shows the returns, in percentage, of the fixed income during recessions.

Bond yields have jumped to levels unseen in many years, presenting an unmissable opportunity for investors to secure higher yields for the long term. The potential for increased returns is enhanced by the appreciation in prices, an aspect worth noting. Moreover, if the Federal Reserve indeed concludes its current rate-hiking cycle and initiates interest rate reductions in 2024, cash yields would decrease, so investing in bonds should be an attractive option. Typically, the term structure of the interest curve generally follows suit, making now an opportune moment for investors to purchase bonds. Doing so enables them to secure yields at comparatively elevated levels and maintain these rates for an extended period.

Looking beyond the U.S. market, Europe holds potentially more enticing prospects, despite lower absolute yields. Unlike the U.S., Europe is transitioning from not just near-zero but negative interest rate environments, now offering positive real interest rates and broader credit spreads. This implies a higher risk premium for bonds of similar ratings in Europe compared to their U.S. counterparts.

Projections suggest that long-term bonds are poised to perform well in 2024. Investors can lock in higher yields now and also have a mark-to-market increase in the value of the bonds as yields decrease. We anticipate an increase in total returns for bonds, stemming from the yield earned and price appreciation.

In our assessment, the era of zero policy rates and extensive quantitative easing is over. The return to a "normal" bond market implies positive real returns during periods of economic expansion, so looking ahead to 2024 and even 2025, the bond market will be a good place to invest.

Corporate bonds. This year there could be many defaults. More risk, more yields.

During the third quarter of 2023, the price of high-yield bonds from emerging markets plummeted to its lowest point since the close of 2022. Although there has been a subsequent recovery, the prices continue to lag behind their normal levels, with average yields hovering near 10%.

A noteworthy observation is the widening yield spread between emerging market and US high-yield bonds, surpassing historical averages despite the generally stronger credit profiles of emerging market companies. These companies exhibit an average net debt-to-EBITDA ratio between 1.7 and 2.1 times, nearly half that of their U.S. counterparts, which have a ratio roughly between 3 and 4.1 times, further, the companies in emerging markets have healthier free cash flow. While the anticipated default rate for emerging markets by the close of 2023 stands at 7%, a significant portion of these defaults stems from a specific sector—real estate and the main country with this issue in China. On the other hand, in Europe, concerns about a recession are penalising subprime borrowers. The credit spread against US Triple-C issuers is presently at its highest since 2009. Europe's riskiest corporate bonds currently yield an average of around 19%, while the least-rated US corporate bonds yield an average of roughly 13%.

In our assessment, this landscape appears favourable for long-term investors equipped to weather volatility and take advantage of the appealing opportunities presented by bonds.

This commentary is for information purposes only and does not take into account the specific circumstances of any recipient. The information contained in this commentary does not constitute the provision of investment advice nor a recommendation, offer or solicitation to acquire (or dispose of) any financial instruments and/or services. Prior to making any investment decision investors should seek independent professional advice and draw their own conclusions regarding suitability of any transaction including the economic benefits and risks and legal, regulatory, credit, accounting and tax implications. The past performance of financial instruments is not indicative of future results and you may get back less than the amount you invested.

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