Review 2023 & Outlook 2024 – Fixed Income Strategy

Central banks’ monetary-policy pivot will go down as the highlight of 2023. However, now that the disinflationary cycle solidly in place, questions are being raised regarding the pace and sustainability that it can maintain without triggering a major economic disruption. Is a perfect landing possible in 2024? Very hard to say…

The wind have shifted

After spending 2022 in panic mode, the markets changed their tone radically in 2023. Core inflation(1) receded and investors seemed to be pricing in a perfect landing(2) scenario in which central banks would raise rates high enough to stop inflation, but not so high as to excessively compromise economic growth. Central banks were therefore believed to have done what was necessary to bring inflation under control, at the cost of steep interest-rate hikes that continued until October and hawkish language throughout the year. However, the impact of monetary tightening is still not clear. Central banks are now in a wait-and-see phase. Inflation hasn’t yet returned to the target, but it is on the right track and could gradually do so. While the economy is holding up for the moment, central banks are keeping a close eye on the effects of monetary tightening, as economic activity figures have become more lukewarm. Have central banks avoided making the one hike too many that might have caused a hard landing(3)? As they themselves admit, the direction of monetary policies will depend on a set of macroeconomic data that will guide their decisions in the coming months.

Some divergences at both sides of the Atlantic 

A distinction is to be made on the inflation fronts in Europe and the US. In the US, while it has declined, inflation remains high, and the job market is still strong. The US economy has been surprisingly resilient throughout the year, but the factors that supported it are likely to fade in 2024. The hyper-expansionary budget, the end of the student loan moratorium, the mostly used up Covid savings, etc. are all likely to sap momentum in the coming months. The ECB cannot easily take on a more hawkish stance than the Fed, as economic activity is weaker in Europe than in the US; nor can it be overly dovish , as inflation is still far from its target. Moreover, the euro zone job market requires less care, as it is more closely regulated.

The utopia of a perfect landing 

Meanwhile, investors seem to be convinced that central banks have calibrated their stance perfectly, a conviction that is feeding the “perfect landing” scenario. Inflation expectations are adhering to this “Goldilocks” scenario with a gradual, steady and unified decline to the 2% target in all regions. This is not the first time that investors have read too much into a trend. With inflation having already begun to slow down in late 2022, the consensus was expecting far fewer hikes than actually occurred in 2023. In reaction, yield curves inverted drastically. This also forced central banks into very firm language, summed up in the expression ‘higher for longer”(5), in order to make clear that no rate cuts were planned in the short term. However, as they always want to stay ahead of the curve, investors are pricing in rate cuts for far earlier than announced. The consensus is forecasting six rate cuts in 2024, with a first one coming in March, whereas the Fed itself is forecasting no more than three and late in the year. The easing of financial conditions arising from market expectations is raising the spectre of a game of liar’s poker between the markets and the central banks and, hence, is causing volatility in interest rates.

Careful of excessive optimisme 

Against this backdrop, we remain on high alert. Historically, each major monetary tightening phase has ended up causing negative impacts on the economy. The latest has occurred quite rapidly, and we have not yet seen heavy repercussions in this cycle. As it generally takes six to eight months for monetary policy to spill over into the real economy, we are still waiting for the impact of the latest rate hikes. Hawkish credit conditions are weighing on economic growth and the number of new corporate loans has already declined. In light of these conditions, we don’t expect a soft or perfect landing and doubt the resilience of the economy in the coming months. Regardless of whether they are better or worse than expected, macroeconomic data are also likely to cause volatility in interest rates in 2024. The US presidential election and budget projections will also bear watching during the year. Donald Trump appears to already be on the winning track before the campaign has even begun, and election watchers are now wondering what policies he will pursue. Between the optimism of the consensus, a central bank that plans to keep rates higher for longer, and the risk of a steepening in the yield curve, it is hard to say which way the markets are headed. 

The credit market is still on track but the outlook is less favourable

Corporate bond spreads(6) are at their historical averages, and valuations are not stretched very much. But as investors are betting on a perfect landing scenario, if expectations were to worsen, risk premiums would rise. In investment grade(7), this trend will probably be offset by a decline in short-term rates, especially as many companies in the bond pool feature resilient profiles and solid fundamentals. Few defaults have occurred in recent months, and there have been more upgrades than downgrades. This trend could nonetheless reverse itself next year in reaction to higher financing costs and pressure on margins. High yield may therefore be in for a challenging period(8). 

More broadly, 2024 could be challenging on the credit market. It is hard to estimate the extent of the potential for a cyclical downturn, but there is clearly a risk of the market’s getting carried away. Estimates of defaults were already generous in 2023 and could be even more so in the coming years. As things now stand, it is hard to outperform under a positive scenario, but if the situation were to worsen, we would have to be able to react rapidly. We therefore want to retain some manoeuvring room and to be able to handle an increase in volatility.

Reducing risk and raising sensitivity

We have reached a point in the cycle where we believe it is worth raising the sensitivity of portfolios. Meanwhile, we are positioned on the short section of the investment grade curve while seeking to enhance the aggregate credit quality of selected bonds and while preferring defensives to cyclicals. However, the yearend fixed-income rally is pushing us into a more tactical stances in managing sensitivity. Although yields may look attractive, especially in high yield or financial subordinates, they carry a high beta(9) that we have sought to gradually reduce within portfolios throughout the year. We nonetheless continue to engage in bond picking(10) to exploit the carry trade on these bonds in intermediate maturities and through some sector opportunities such as financials.

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