Take risk, take credit

As you were 

Did you get the central banks’ collective memo? There is no compelling evidence to cut interest rates anytime soon. So, as you were. We are still on top of Table Mountain and mid-year looks the most likely time for the first interest rate cut. Of course, that won’t stop endless conversations about how far officials at the Federal Reserve (Fed), the Bank of England (BoE) and the European Central Bank (ECB) have moved on the hawkishness to dovishness scale. They also always retain the right to surprise us. Two members of the BoE’s Monetary Policy Committee voted to increase interest rates in the UK at its 1 February meeting. Maybe they didn’t read the memo.

More patience 

Behind the memo though, the message is that lower interest rates are coming. Lower rates through 2024 remains one of the key investment themes. Market pricing has adjusted to the timing a little. In the US, the first cut is priced for either May or June, but rates are still expected to be over 100 basis points (bp) lower by the end of the year. In the UK, the market is betting the first cut will come in June and rates will fall by 100bp this year. For the Eurozone, again June looks the most priced in for the first cut - and rates are expected to fall to 2.5% by year-end, from 4.0% today. Central banks’ hidden message is to be patient, as more evidence of slower growth is needed, and inflation needs to fall further, before there are rate cuts. Given what is priced in, markets are likely to experience bouts of disappointment in the weeks and months ahead if the data flow hoped for, doesn’t materialise.

Home in the range 

As mentioned last week, betting on rate cuts over and above what is priced in does not look like a great trade now. It also means I can’t get that excited about government bonds other than from a carry and roll down point of view (there are lots of government bonds trading on prices well below par because of what happened in 2022 and 2023 and they will slowly increase in price). Along with my fixed income colleagues, I often trot out the mantra that yield does not necessarily equal return, especially over relatively short-term horizons. But today, in the case of most developed government bond markets, it probably does. To qualify that, when rates are cut, government yield curves will steepen so there will be capital returns in the short-to-medium part of the curve. It’s not something to get too excited about though. But benchmark 10-year yields are not likely to stray too much from current levels.

Poor returns from safe assets 

As a standalone investment, government bonds have been poor performers over the last decade. Measured by total returns relative to volatility, long-duration risk-free bonds have performed much worse than credit and equities. When central banks were keeping bond yields low through quantitative easing, the trade-off for bond holders was that they benefitted from the implicit promise of no capital losses and plenty of liquidity. That served the macro policy narrative at the time and government bond holders, who are primarily liability-driven investors, were willing to forego returns in order to benefit from the safety net provided by central banks. That contract was terminated in 2022. After paying for the long period of central bank support, government bond holders are back to enjoying the benefits of carry and the challenge of interest rate risk. Outside of a downturn in the global economy, they are likely to continue to underperform other assets on a relative basis.

Risk rewards 

Risk assets are more interesting. They performed well last year. The Nasdaq Composite Index had a total return of 45%; the S&P 500 delivered 26% and the CCC-rated index of the US high yield market delivered a 20.4% total return. I have been on the road seeing investors in Europe over the last two weeks. I am starting to get the feeling there is more optimism around taking risk. Many investors seem to share my positive view on credit and high yield, although the outlook for equities is less clear. There is a general agreement that rates have peaked and that fixed income markets offer the prospect of higher returns, driven by income, without an obvious risk of what would drive credit risk premiums higher.

Cash re-investment risk 

With government bond yields trading in a range until we get some shift in official interest rates, credit looks attractive because of the additional spread return investors get, even with taking on additional duration risk compared to cash. As I said last week, you don’t get capital returns on cash when rates come down, just a lower rate of return. There is significant re-investment risk (say you invest in three-month US Treasury bills today at 5.33% it is likely that by April that rate will have come down to 4.92% and by July to 4.2% and then to around 4.0% by October – according to current forward market pricing). That would mean a full year compound return of 4.7%. And, if markets are right, an even lower return the following year. Credit markets offer higher potential returns with a starting yield of around 5.1% for US investment grade and the potential for capital gains adding to the total return.

Stable-to-lower rates and attractive credit spreads are key characteristics of the outlook for fixed income this year. Fundamentals are also supportive, limiting the risk of a big increase in credit spreads. This cycle has been different to previous ones as it has not seen big increases in leverage, in either the corporate or consumer sectors. During the pandemic, governments provided fiscal support and central banks provided lots of liquidity. There was no need for huge borrowing splurges. Hence why we have seen a surprisingly limited impact (so far) of higher rates on economic activity. According to estimates, leverage ratios in the US investment grade bond market are around 3.0 times while in the high yield market they are around 4.0 times (measured as the level of long-term debt relative to earnings and much higher at the onset of the pandemic and in previous cycles). 

Government is where the debt problem is 

Since the end of 2008, the US Treasury’s outstanding debt has risen by 289% compared to corporate debt rising by around 130% - this data comes from the Fed’s Flow of Funds report. Outstanding Treasury debt is around 6.0 times the level of annual government revenue (mostly taxes). The government is more indebted and more leveraged than the US corporate sector on many measures. I’m not sure corporate bond spreads need to go up much more – although of course, rising government borrowing could push up Treasury yields, so hedging duration risk at some point may be a necessity. There will be lots written on Donald Trump’s potential policy choices if he wins November’s US Presidential Election and a surge in borrowing from Washington might be an outcome of these. And it is not just a concern about the US.

In its November 2023 Economic Outlook, the Organisation for Economic Co-operation and Development (OECD) forecast that the US government’s gross financial liabilities (debt) will stand at almost 124% of GDP this year. For the UK the estimate is 103%, for France 120% and for Italy, 148%. Big, developed economies have seen increases in outstanding debt to GDP ratios since the pandemic and there are few signs of these ratios coming down, especially with higher real interest rates as inflation subsides. As I discussed last week, this is a key reason why real rates are likely to remain near to, or potentially above, current levels for some time.

Small bank worries again? 

I digress here a little. The point is that credit should continue to reward investors over and above the risk-free rate. Some doubters may point to this week’s news about another regional bank issue and the underlying concerns about parts of the commercial real estate market. These concerns have been known for some time with weak demand for some types of commercial real estate in the wake of the pandemic, and interest costs rising for leverage assets and lenders in this space. Is this going to be a systemic issue for the US financial system? I doubt it at this point with the bulk of the financial sector in robust health in the US. But, as always, watch this space. Any more bad news on smaller banks or the real estate sector, combined with weaker data, will raise noise around the Fed and the need for rates cuts coming sooner rather than later. Again, though, a lot is priced in.

Tech keeps growing 

My other core theme for 2024 is US exceptionalism, particularly in the field of technology. This week saw stellar results from the sector. For the fourth quarter reporting season, technology companies have, overall, beaten expectations and recorded 13% earnings growth compared to just 7% growth for the S&P 500 itself. The total return for the technology sector has been 5.3%, year to date – 140bp more than the market’s total return. There has been no let-up in news about AI and investment spending on technology – both hardware and software – appears to remain robust.

The 2024 guide is still valid 

With one month down, equity returns have been better than expected (+2% for the MSCI World) while bond returns have been a bit of a damp squib (-1% for the ICE Global Bond Market index). But the key themes I have focussed on since the end of 2023 remain in place as a guide to where to invest this year. The first is stable-to-lower interest rates in the US and Europe, with central banks eventually easing in response to the soft-ish landing for the global economy. The second is the greater income opportunities in fixed income, with high yield markets still offering superior risk-adjusted returns against a backdrop where defaults continue to run at very manageable levels. The third is technology remaining a driver of equity returns. So, take risk and take credit, at least for now.

(Performance data/data sources: Refinitiv DataStream, Bloomberg, as of 2 February 2024). Past performance should not be seen as a guide to future returns.