Fixed income in flux – the case for a new outlook

Francois Collet, Deputy CIO for fixed income at DNCA discusses his current outlook for markets, what could upset this view why he believes that nimbleness and true diversification will be essential in the current market.

What is your current macro outlook for Q1 and beyond?

Francois Collet: After a stronger-than-expected 2023, it does seem that recession will be avoided once again in 2024, even if growth is likely to moderate. Last year saw rapid disinflation from very elevated levels, and we think that this decline in inflation, coupled with a consequent rise in real wages, will keep consumption at decent levels. You are already seeing this in the US, where consumer sentiment is improving – and remember that consumption is 70% of the US economy.

There are nascent signs that Europe, and perhaps even China, are beginning to bottom – especially when you look at leading indicators and countries like South Korea or Sweden. In China, which was a major disappointment in 2023, there are positive signs emerging in response to the measures put in place by the People’s Bank of China (PBoC) since late spring last year. This should help Europe and its manufacturing sector.

And, crucially, central banks have begun to cautiously embrace an easing cycle – hoping, we think, to achieve a soft landing. The risks of overtightening and sending the global economy into a recession are therefore quite low, especially as some central banks – notably the US Federal Reserve – have emphasised a preference to lower rates to keep the real rates less restrictive. That’s a big change from 2022 and even 2023 where there was a tightening bias.

Fears of a recession therefore seem to be allayed for 2024. Even as economies are set to slow down, a soft landing is coming into view and, with more accommodative central banks, this should reassure investors.

What could upset this view?

FC: While the economic outlook appears benign, the geopolitical situation is less certain. The ongoing crisis in the Middle East remains a risk for the global economy. Further escalation of the conflict could have a major impact on oil prices and economic activity.

Remember, it was supply chain shocks and the spiraling price of oil that really saw inflation skyrocket in 2022. If there is an oil shock, the eurozone will have to demonstrate that it can tighten its budget without causing too much damage to growth.

Another concern is the sustainability of public debt in some countries, with debt levels pushing extremes. The US will have to demonstrate that it can maintain an accommodative fiscal policy without putting pressure on bond yields, which may require the Federal Reserve to “monetise” the deficits eventually.

While an end to Quantitative Tightening looks to be on the cards sometime in 2024, before then the issuance of T bonds will reach new records, and is likely to exceed investor appetite for long-term financial assets, with an impact on the long end of the yield curves.

For now, Janet Yellen has allayed market fears with market-friendly financing announcements, but we are not sure this will continue for the entire year as deficits continue to grow.

Do fiscal dominance, deglobalisation, geopolitical tension, resource constraints, and the green transition mean investors need to embrace a new outlook?

FC: All of these are novel concerns that investors should be paying attention to. Fiscal spending was not an issue coming out of 2008 and governments embraced austerity; now we have some governments that are embracing de facto 'modern monetary theory' policies -running wartime deficits when unemployment is near record lows. That’s a huge shift.

Deglobalisation is a relatively new phenomenon that should continue. Geopolitical tensions, especially in the Middle East, are at their highest in a generation or more. And the green transition will continue – against a backdrop of growing resource constraints. There’s also the issue of secularly tighter employment markets, at a time when productivity has not been increasing a lot. That’s a recipe for higher wage growth and core inflation.

Given this, we do think that investors need to embrace a new outlook. While disinflation should continue for the foreseeable future, a lot of this is because of base effects – such as housing and energy – which can’t continue forever.

In fact, we would not be surprised to see inflation settle at a higher level than before and for inflation volatility to remain higher, and you are already seeing this in some indicators like long-term inflation expectations.

This last part is important: companies and investors can get used to inflation perhaps settling at a moderately higher level, but what they haven’t had to contend with for a generation is sharp swings in prices, which affects asset correlations and future spending plans.

Where previously the assumption was that a portfolio of stocks and bonds, and maybe some real estate was diverse enough to provide a decent level of mitigation against market shocks, 2022 offered a cogent reminder that different and diverse aren’t necessarily always the same thing. For example, as we saw in 2022, an oil shock could see both sell off in tandem. As a result, investors will have to be much more agile than before.

What could this mean for assets? Is higher asset price volatility here to stay if inflation volatility remains high?

FC: Yes. Higher inflation volatility is particularly damaging for several reasons. First, if central banks are serious about wanting to keep inflation stable at around 2% - and we believe they are – then their reaction function will have to be more aggressive, more often, to tame inflation when it rises much above 2%. That’s obviously bad for nearly all assets as they drain liquidity and tighten financial conditions like 2022.

Second, if inflation is less certain and more volatile, bond investors are likely to demand a higher term premium for holding longer dated bonds, while yields are likely to spike higher on occasion.

In very simple terms, this could weigh on government bonds, steepen yield curves and hurt equities - whose valuations are discounted against bond yields and the ‘risk free rate’. Equity valuations in some countries like the US are not cheap and may be susceptible to a de-rating if we see inflation settle higher or yields spike like we did in 2022 – particularly interest rate sensitive, longer duration stocks like technology.

We also saw this briefly in 2023, when the US government’s aggressive fiscal policies saw the term premia spike, hurting equities. So, in 2022 we had an oil price shock, and in 2023 we had fiscal issues. Both remain risks.

So, as I said earlier, investors need to think about true diversification. The 60/40 portfolio and the idea that stocks and bonds will always be inversely correlated is a relatively new phenomenon. If you look back throughout history, and especially when governments have targeted the real economy and economic growth, as they are now, this has typically not been the case. It’s a reality that investors should embrace or be open minded to.

Will this favour active investors who can embrace flexibility and real diversification?

FC: We think so. Higher future volatility is likely to drag down expected returns for most assets and make things difficult for allocators. The 'great moderation' could end up being a historical aberration. But we believe this could actually be a boon for those that can take advantage of it.

We saw in 2022 the number one diversifier for equity investors was actually oil, and energy was the only equity sector that posted strong returns as bond yields rose. This makes sense since oil directly feeds into inflation. Yet many investors, whether because of ESG constraints or otherwise, simply didn’t have the flexibility to allocate and diversify in this way.

The same can be said for fixed income. While DNCA’s cash-plus flexible bond strategy fared very well, due to their ability to shorten duration or even short longer duration bonds outright, most traditional fixed income funds don’t have that luxury. There was a lot of volatility in fixed income market in 2023 due to the ever-changing expectations on interest rate levels in both US and Europe. Most traditional fixed income investing strategies have loaded on duration early in the year and therefore have experienced a bumpy ride until November 2023. However, the first two months of 2024 again have reminded us all that markets may have been too ambitious in their interest rate cut forecasts. Meanwhile at DNCA, our team has been diligently watching economic indicators and focuses on actively managing duration within the portfolio and so we are pleased that our strategy may enjoy more stability throughout the period.

This is really why we take a highly diversified approach and aims to develop multiple alpha sources for our fixed income portfolios. We think traditional fixed income will continue to struggle and may not offer the ballast or defence that it once did, and which investors still need.

With the right expertise, volatility can be turned from a foe to a friend. The 40-year bond bull market may be ending; but with the help of strategies like duration management, arbitrage, relative value etc, we believe a new bull market for nimble and intelligent investors is just beginning.