Q1 recap: macro drivers and fixed income performance

Quarter ends are always a useful time to take a step back and assess what the main macro drivers during the quarter were, which trades worked and which did not and to refresh macro views for the next period. Q1 2024 is now behind us, and we find a few interesting points worth mentioning about returns and their drivers.

Starting with government bonds, it is fair to say that returns during Q1 disappointed many with 10Y and 30Y US Treasuries selling off by 32 basis points (bps) and 37 bps respectively. These figures translated into total returns of -1.55% and nearly -4.0% for the two benchmarks. Gilt yields increased by approximately 40 bps and 30 bps at the 10Y and 30Y points, while German bunds moved in the same direction by 30 bps and 20 bps, respectively. It should be remembered that these moves came after a fierce rally in Q4 2023. Regarding the short end of the curves, expectations of rate cuts have moderated significantly. At the beginning of the first quarter, government bond markets were pricing in for 2024 a total of six cuts by the Fed, almost seven by the BoE and six by the ECB. Today those numbers are closer to three cuts according to Bloomberg. Our view is that this volatility was a result of market expectations being too complacent with the inflation picture, more than central banks or the macro outlook changing too dramatically during the quarter. Inflation evolved more or less in line with central banks’ expectations in Q1 and we think they remain, therefore, on track to start cutting rates later this year. This is the case even in the US where inflation surprised on the upside.

Spread products also surprised many for the opposite reasons. Those who have been predicting a collapse in high yield (HY) and levered loans were proven wrong once again. Although returns were understandably dwarfed by Q4 2023’s, nevertheless US HY, EUR HY and GBP HY indices returned 1.5%, 1.6% and 2.8% respectively in their local currencies. Default rates increased somewhat, in line with expectations, but nowhere near a level that could cause a major disruption in our opinion. Levered loans followed a similar trend and Collateralised Loan Obligations (CLOs) were once again amongst the top performers in the quarter. CLO spreads in EUR tightened anywhere from 30 bps at the AAA level to 100 bps in BBs and 150 bps in single Bs. Given the elevated carry these bonds started the year with, total returns at the BB and single B level were in 6%+ area. Investment grade (IG) credit outperformed government bonds markedly as spreads absorbed part of the move higher in yields with shorter maturities delivering encouraging returns. Financials also outperformed with the CoCo index delivering a positive 3.5% return in the quarter, as market commentators voiced that the sector continued to look undervalued from a fundamentals point of view. We think it’s also important to mention that financials shrugged off name specific headlines related to certain banks’ Commercial Real Estate (CRE) exposures both in Europe and in the US. This appears to indicate that markets see CRE issues as unlikely to cause a systemic shock, a view with which we concur. 

The main reason we saw such a strong performance in spread products was that the ghosts of a hard landing continued to dissipate. This along with a more benign inflation outlook that has allowed central banks to confirm they are likely to cut rates in the not too distant future, provided a nice tailwind to risky assets. The technical picture also played a role. Fund managers and investors had a strong bid for fixed income products generally speaking, which was reflected in the ease with which large amounts of IG and HY net supply were absorbed in the first three months of the year.  

Looking forward to the rest of the year, the growth outlook appears less uncertain than at the beginning of the quarter. Growth projections have not improved substantially in the last three months, but we think it is fair to say that the aggressive moves in risky assets have been validated by a resilient economy and a lower probability of a hard landing. This has been particularly important in Europe and the UK, where growth has been close to zero for several quarters now, with both regions having seen signs that the low cyclical point in growth is already behind us; Purchasing Managers Indices (PMIs) - both Manufacturing and Services - have bounced back slowly from the lows which supports consensus projections for a timid move upwards quarter after quarter as the year progresses. 

What are the main risks as we see them? The macro scenario that would inflict the most damaging consequences to fixed income markets would be a sustained renewed spike in inflation. However we attach a low probability to this scenario; we do note though that services inflation needs to continue its downward trend as goods disinflation seems to be reaching exhaustion. Moreover, we have witnessed higher inflation prints than forecasted in the US in Q1 with markets (and the Fed) extending the timeline for inflation to return to target rather than having doubts about whether or not this will happen. We agree with this view but we acknowledge that inflation cannot keep surprising on the upside in the future or else the Fed and markets might start questioning more seriously the likelihood of the aforementioned thesis. 

Another one worth mentioning in the list of main risk events we see is geopolitical risk. There is little dispute about the fact that geopolitical risks have increased in the last few years, the latest of which has materialised in Gaza. Russia’s invasion of Ukraine looks to be far from reaching some sort of resolution with Putin hardening his stance towards the West and Ukraine after the Russian election and the recent ISIS attack in Moscow. The conflict seems to be escalating rather than deescalating. Additionally, China has a domestic problem with aggregated demand being depressed as the property and confidence crisis continues with there appearing to be no solution in sight to these and local government debt problems. This overcapacity has reportedly prompted Chinese companies to dump goods on the rest of the world at reduced prices causing several antidumping actions by European authorities. In this heated context, it takes less than what it would usually take to cause a major geopolitical event. 

We think the script going forward looks similar yet not exactly the same as in previous quarters. With all-in yields at very attractive levels in our opinion, we do believe it makes sense to continue moving up in credit quality at the margin. Spreads have tightened across the board with sectors that were, in our view, mispriced to their fundamentals (notably CLOs and financials) closing the gap to the rest of spread products. We continue to believe spreads in these two sectors offer very attractive relative value opportunities but the chances of spread tightening of the magnitude seen in the last six months are less likely. Carry will be the engine of total returns going forward and in the absence of a hard landing and a renewed spike in inflation, we think both credit and government bonds should provide investors with decent risk-adjusted returns going forward.