“This time next year, Rodney…”
After a horrible year for financial markets in 2022, the macro-outlook for 2023 had a lot of consensus views, with most predicting a much better year ahead, helped by supportive rate cuts from central banks and positive returns from both government bonds and credit.
This optimism seemed justified at the start of the year, as the recovery in the final quarter of 2022 continued through January. However, the US regional banking crisis and the collapse of Credit Suisse in Europe quickly soured the positive investor sentiment. As the year progressed, central banks continued to fight inflation and consistently and aggressively pushed a “higher for longer” interest rate mantra. This rhetoric negatively impacted government bonds, which in turn weighed on fixed income performance for much of the year.
Flows into fixed income were also negatively impacted, with rates volatility encouraging investors to stay on the sidelines, despite the attractive yields on offer.
Despite these negative drivers, however, many sectors within credit have delivered attractive returns this year, aided in no small part by high starting yields and significant carry, which has helped to absorb negative macro events.
As we look forward to 2024, starting yields continue to look very attractive in our view, and in most cases even higher than where we started 2023. And, with optimism that peak base rates have been achieved, confidence is high that the year ahead can deliver stronger returns.
Synchronising the path of base rate cuts, government bond yields and credit spreads are likely to play a big role in positioning for asset managers next year. We expect that rates will lead the way, as hope of a goldilocks soft landing gives way to fears of a weaker economy and rate cuts from various central banks. If the economy weakens, as we expect, this will likely lead to spread widening across credit sectors, which we think could provide an opportune time to book profits on rates and increase the holdings of credit, where bonds are currently offering compelling looking yield opportunities.
As is customary, we start with a look back at last year’s predictions, and despite a lot of volatility, many of the sectors delivered what we anticipated, but as can be expected, there were also very notable areas of divergence.
In the US, we expected base rates to be hiked to 4.5% in December, and we felt they would peak between 4.5-5%, and although we didn’t expect a Federal Reserve pivot, we thought that the expectation of rate cuts in 2024 would help 10-year yields to end 2023 at ~ 3.75%. The UK was still recovering from the disastrous mini-budget in September, but with rates at 3%, we expected another 100bps of hikes from the Bank of England and thought that 10-year yields would need to climb towards 4%. In the Eurozone, which was facing the prospect of energy rationing and a recession, we expected the European Central Bank to hike rates by another 150bps, to 3%, but there was much debate regarding what could be achieved given the economic backdrop. We also expected 10-year bund yields to end 2023 in the range of 2.5-2.75%.
Ultimately, the global economy remained much more resilient than expected, allowing central banks to be more aggressive in hiking rates, leaving our rates view well short of current levels. Our expectations for gilt and bund yields were fairly accurate, although treasury yields are higher now than we expected.
In terms of returns from corporate credit, we expected spreads to widen marginally, but didn’t expect rates headwinds, and therefore felt that both investment grade and high yield indices (£, $ and €) would reward investors well, and deliver the yield being advertised at the start of the year. Instead, we saw spreads tighten and rates being a hinderance, which net-net, has led to the same expected result, and except for $ IG, most corporate indices are indeed on track to deliver their advertised yield for the year.
The biggest area of divergence was, unsurprisingly, the AT1 market following the Credit Suisse collapse. Nevertheless, and somewhat surprisingly, spreads have performed better than we expected, with the index being roughly 60bps tighter than our starting point of 509, whereas we only expected 30bps of tightening. But, while the index has recovered, it is only marginally positive on a year-to-date basis and well short of delivering the 8 to 10% return we had expected.
European Asset Backed Securities (ABS) was another area that delivered what we expected, with spreads grinding tighter in most areas, and some areas, such as BBB CLOs, significantly exceeded our expectations. With few negative credit issues, spreads tightening and coupons resetting higher with higher rates, high current coupons kept the sector looking very attractive, and coupled with strong returns, the sector has been the star performer in 2023 as at the time of writing.
Strong returns ahead, but the road may be winding
Looking ahead to next year, we have seen a lot of diverging opinions among the investment banking outlooks, and similarly, we had a very lively debate here at TwentyFour regarding the likely path for rates and credit spreads through the course of next year. Ultimately, however, there is strong consensus that 2024 could be a very rewarding year for investment returns.
This time last year, after the torrid 2022, we felt there were fewer unknowns ahead, and importantly, there was a lot of bad news being priced into both government and bond markets. When bond prices reflect a lot of bad news, and yields are also high providing compensation for ever more negativity, the outlook for returns typically looks attractive, and ultimately, that is what many sectors have delivered.
However, given the levels of volatility in November alone, it’s worth acknowledging that if we had written this at the start of November the picture would probably have been quite different; for example, at October month-end, the $ high yield index was only on track to deliver half of the return predicted by the yields on offer at year-end 2022. The index is now, however, expected to deliver most, if not all, of this advertised yield.
The impact of the government bond rallies this November alone, (currently over 60bps for 10-year treasuries at time of writing), has added significantly to returns, starting with those sectors most correlated to rates. Credit spreads have rallied tighter as well, as optimism grows that the hiking cycle is behind us, and this has broadened the rally to higher-yielding sectors as well.
The opportunity cost of sitting on the sidelines, when yields are this attractive, has been brought sharply into focus, encouraging investors to put money to work. In addition, it also highlights the speed at which markets can move and the need to be positioned for the medium term, even as short-term movements might be painful. The feeling among the TwentyFour PMs is that synchronising each component of next year’s returns will be extremely difficult. Along with having to forecast how the economic cycle evolves, central bankers’ reactions to the data will be just as important, and maybe more important for short term moves. Various Fed members have said that they are happy to go “too far” to cool inflation, and we do not doubt that – this was the Fed that ignored spiking inflation, after all, until the unemployment rate was below 4% again.
In addition to the forecasting of central bank actions, we expect the performance of credit will also be dependent on quite a few factors, and should the economies slow more quickly, or to a lower level than expected, markets could be prone to overreactions.
In our outlook for last year, we expected a soft-ish landing in the US, with the economy expected to enter a mild recession, while we thought that the UK and Europe would also likely enter recession. Obviously, the US has been more resilient than expected, but we continue to hold the view that as we enter the late part of the cycle, a mild recession is more likely than a goldilocks soft landing. The US consumer does seem to be weakening and, although we are not expecting a significant increase in unemployment, we think the full impact of higher rates is still to be felt in the economy and the tighter financial conditions will ultimately lead to a less buoyant consumer.
We also think that the US regional bank problem will persist, and we expect the Fed’s Bank Term Funding Program to be extended past its initial one-year term. US regional banks are as a collective heavily exposed to Commercial Real Estate (CRE), not all of which is poor quality and not all loans are immediately due, but a combination of these worries, coupled with deposit balance and liquidity weakness, is likely to weigh negatively on the risk appetite and lending capacity at these banks.
Ultimately, our views on this have only marginally changed, with a soft-ish landing base case now seen as at 50%, while we have an equal weight for a hard and soft landing, having decreased our soft-landing probability to 25% from 30% despite the resilience of the US economy.
The US and Fed
Federal Reserve policy decisions and the associated rates volatility played a huge role in markets this year, and this is likely to continue in 2024 where we will also have a presidential election to contend with.
While the path ahead for government bond yields cannot be easily synchronised, confidence is high that rates will be more supportive next year. There are plenty of variables that complicate the treasury debate, however, including, but not limited to, the path of inflation from here, both headline and core, the impact of rapidly falling money supply on inflation, the monetary policy lag, the amount of issuance required to fund the deficit, the maturity mix of this supply, the lower purchases of USTs by China and Japan, the shape of the yield curve, and the path of real yields as inflation continues to fall.
Inflation in the US has been the biggest driver of rates policy since early 2022 but as CPI approaches more comfortable levels for the Fed, the path of the US economy is going to play a bigger role in what they ultimately decide. Our consensus view is that the US will still skirt with a recession, and probably experience a mild one, driven by the tighter financial conditions being experienced by consumers and corporates alike.
We think the recession may be mild, with a V-shaped recovery, but with markets broadly pricing in a goldilocks, soft landing, if economic data is weaker, the Fed will feel pressure to cut, particularly if inflation is close to target.
It must be said that the US economy has held up remarkably well, but ultimately we think you can put this down to the consumer remaining resilient, thanks primarily to wage hikes, low unemployment and a comforting holding of excess savings. However, there are more frequent signs appearing that the consumer is now weakening. The high current yields are also beginning to impact negatively on corporate activity, and we saw very weak demand for credit in the most recent senior loan officer survey in the US.
The US economy looks to be in late cycle, and therefore more vulnerable to an external shock - although it is impossible to predict, or time, an event like this. However, should the economy suffer a significant slowdown or recession, we think it will very likely have been caused by the Fed’s rate-hiking policy – but importantly, the Fed is now in a place to help again by cutting rates. This is a strong position to be in, and healthier for the market and while we think the Fed will be supportive, we are not predicting a return of low, covid-era rates, or quantitative easing.
We expect the Fed to cut rates next year – maybe up to 100bps, but our base case is for fewer cuts. However, the direction of travel for 10-year yields is difficult to predict, even assuming these cuts happen. The rational and most likely reaction is a rally along the curve, with a parallel move lower in yield. But increased supply of treasuries, yield curve normalisation and quantitative tightening (QT), will all play a part in determining where yields ultimately settle, and there is a case to be made for an aggressive bull steepening, leaving longer rates relatively high even after numerous rate cuts. We also think that QT could become a bigger topic next year, and if too much money is sucked out of banks in the US, this will negatively impact on their willingness to lend, further hampering the economy.
Importantly though, we do not expect longer-dated yields to be a headwind next year. At worst, we think rates will deliver their coupons, although, given the anecdotal evidence emerging that the US consumer is becoming less resilient, and corporations are less willing to borrow, there is a possibility that yields ratchet lower on weak data and the expectation of more rate cuts.
The Eurozone and ECB
The consensus view on the Eurozone is that the trading bloc is more likely to suffer a recession than the US, but again, a hard landing is not expected. The Eurozone economy has already succumbed to a mild negative quarter-on-quarter growth rate in the third quarter of this year, and with Germany more exposed to the manufacturing sector than many other developed economies, a technical recession at least could be difficult to avoid.
Some European governments have tried to engineer fiscal loosening, however EU rules block this, while in Germany, an attempt to reallocate unused pandemic funds was also recently blocked by its own constitutional court. With rules around deficits being reinstated after having been suspended during the Covid outbreak, next year could see disunity growing again among EU members.
But the inflation story in the Eurozone is very encouraging, with both headline and core inflation responding much quicker to rate hikes than in the US or UK, resulting in headline inflation heading very quickly towards the ECB target.
Controversially maybe, given headline inflation was more than 10% just over 12 months ago, there was support for the view that Eurozone inflation could fall significantly through the 2% target again, driven by the fall in money supply. Business loans in the Eurozone are mostly floating rate, and subsequently the monetary policy lag appears to be much shorter, while the energy price pressures that were being experienced last year have also receded substantially.
With CPI expected to continue its fall, and with the economy expected to weaken further, the ECB could well be able to cut earlier than the Fed, but a range of 75-100bps is our consensus. Short-dated bunds are expected to see the biggest impact of rate cuts, and there was a debate across the PMs as to whether the 10-year could rally tighter from here, being currently at ~2.4%.
The UK and BoE
The UK is also facing an uncertain outlook, but we have to say, the economy has proved to be much more resilient in 2023 than expected. Inflation remained stubbornly high for most of the year, but is finally responding to the rate hikes, while money supply is also falling very quickly in the UK and should help to soften inflation further.
However, while we also expect inflation to fall, we think CPI will remain higher than either the US or the Eurozone during 2024. The tightness of the labour market in the UK, along with reasonable wage rises we have seen, has helped to underpinned inflation, even if there are signs that the jobs market is loosening. In addition, the percentage of people on long-term sick leave is a damaging structural issue, which we think is unlikely to improve in the short term.
The tightening of financial conditions will continue to impact UK corporates, while mortgage holders will increasingly be impacted by the hiking policy, as more mortgages roll off their lower fixed-rate deals (typically three or five years in the UK). Fiscal easing is also a possibility in the lead up to an election next year (although the government could delay this until January 2025 it is highly anticipated to take place in 2024), which would help support the consumer, and maybe slow the fall in inflation.
Keeping one eye on the economy, the BoE is expected to cut between 50-75bps but, again, there is a lot of debate as to the impact this will have further out the curve, with the difference between the 10-year yield and the two-year yield being inverted by around 40bps currently. Given the high inflation and weak economy, it is probably no surprise that consensus was low regarding the end point for 10-year gilts.
Credit – strong returns expected, again
The strong consensus among the PMs is that most credit sectors will enjoy a strong year in 2024, helped by rates markets that, we think at worst should deliver the advertised yield but with the potential to outperform, and yields in credit that are close to the highest seen since the global financial crisis, and certainly well above averages since that time.
The path of spreads during 2024 did generate a lot of debate, with most participants expecting spread widening at some stage during the year, which we expect to be driven by optimism fading that the Fed can engineer a smooth glide into a soft landing. There was also consensus that, as rates are likely to remain high for quite a few quarters, even if they are cut, the impact of these tighter conditions will continue to seep into the markets and weaken both the consumer and corporate world. We know that markets can overreact when spreads widen, but given the attractive yields on offer, being overly prescriptive in terms of timing this widening is unlikely to be a rewarding strategy in our view.
Investment grade corporates have enjoyed a reasonable tightening of spreads this year, ranging from 25bps for $ IG, to 65bps for the £ index, and we expect that some of this tightening will be retracted as the aggressive hiking cycle weakens the economies. However, starting yields, that are still higher than 12 months ago, will help to support total returns during the year, while rates are likely to be more supportive in the event of a weakening economy.
High-yield sectors have also enjoyed spread tightening this year, which has driven the strong performance, and we could certainly see a retracement wider next year. However, the market is underpinned by most corporates being in a healthy financial position with high cash balances and strong interest coverage ratios. The markets are not facing a wave of maturing bonds, with the refinancing walls still being several years away, although primary supply is expected to be higher next year. The lack of issuance last year, however, should also help provide a strong technical support with investors keen to look at new deals, while the rise of the private credit market also provides alternative financing options for companies looking to issue debt. In addition to this, although we expect default rates to rise and remain more elevated through 2025, overall, defaults should remain well contained.
High-yield markets have enjoyed a strong rally in the fourth quarter of this year, but starting yields still look very compelling in our view, with various indices either at or close to their yields 12-months ago. As such we think this should help to generate another strong performance year in 2024, underpinned by stable rates markets.
Banks and insurance were two sectors that significantly underperformed our expectation for most of 2023 and are still lagging even after a strong November rally. The regional banking crisis in the US focused attention on Eurozone banks and, although the issues being faced in the US were not present in European banks, the contagion was felt across the sector. The collapse of Credit Suisse and the AT1 write off was potentially a much bigger issue for the market and certainly investor confidence was hit hard after this event. But the strong words and actions from the Eurozone and UK regulators, coupled with robust earnings from banks throughout the year, along with numerous calls of AT1 bonds, helped the sector to recover strongly. Although the CoCo index was down over 15 points at one stage in the first quarter of 2023, investors regained their confidence in the sector and this index is now positive year-to-date, which should embolden long term investors in AT1s.
The rates headwinds also played a big part in the underperformance of banks and insurance companies. While senior and T2 debt from Euro banks, along with insurance company debt, also underperformed during the US regional bank crisis, these sectors predominately include bonds that are investment grade rated and are therefore highly correlated to government bonds.
Unsurprisingly, with rates headwinds persisting for most of the year, these sectors struggled. Like other areas of fixed income, however, the high starting yields available ultimately helped to drive performance, and spreads in both the bank and insurance indices tightened through the year, although yields are still higher than this time last year.
Given the relative underperformance this year, there was a strong consensus amongst the PMs that European banks will continue their recent outperformance and the return potential for 2024 looks very attractive, right along the capital structure from seniors, to T2s, to AT1s. We also expect the insurance sector to benefit from the more stable rates outlook, and high starting yields. The PMs are conscious that, should the European economy weaken as expected, non-performing loans are likely to rise, and the slowdown in the CRE sector is likely to continue and provide headwinds as well, although European banks are much less exposed than their US counterparts and in general less leverage was offered to CRE lending in Europe.
In addition, Euro banks are well capitalised and very profitable, helped by higher net interest margins, and any need to increase provisions should be well contained within earnings. Overall, there was strong consensus that the financial sectors in Europe would deliver some of the best returns in 2024.
European ABS is another sector we expect to perform very strongly. It was one of our top picks last year, and even after showing very strong returns in 2022 and 2023, we think the coupons and yields available remain very attractive. In our view investors can receive healthy compensation by moving to more junior-rated bonds and with modest cuts to the risk-free rate expected, the floating rate coupons in European ABS will continue to deliver income. The ability to be highly selective in the jurisdiction, lender and pool of assets that support the transaction is a big benefit to ABS investors, and as the economy slows, we think this will be even more important next year.
While we expect the default rate to increase in leverage loans, we don’t think this will be a significant headwind to CLO debt performance, and like the theme running through most of credit, we think the high starting yields should help to produce another strong year. Ultimately, the ABS team here at TwentyFour expect spreads to be no worse, and in some cases tighter, than current levels by the end of the year. This should produce strong returns, that once again, we think could be difficult to beat in any other part of credit.
Emerging markets (EM) have had a less eventful 2023 than last year. As indices left the Russian invasion and China’s property issues behind, spreads in the ICE BofA Emerging Markets Corporate Plus Index (EMCB) have tightened marginally from January, after selling off in March in line with the rest of the riskier assets. Fundamentals in EM look to be pretty reasonable for 2024, with corporates in decent shape, although, like developed markets, the lower end of the ratings spectrum is definitely more vulnerable to refinancing risks in our view. Regarding valuations, higher quality corporates are trading relatively tight, reflecting the caution mentioned on lower quality assets. Our conviction to EM has remained low throughout the year, preferring the better relative value opportunities available in financials, CLOs and developed market corporates, and this is likely to remain the case next year.
Synchronising rates and credit will influence returns
As mentioned at the start, we think the economy will weaken more than the current soft landing narrative, and we expect that this will lead to rate cuts and a government bond rally. This economic weakness will also lead to spread widening, which could be the time to cut rates and increase holdings in credit, where we expect strong returns but also volatility.
The fact that many central banks are now in a position to help the economy again is very important – a few years ago, with rates at rock bottom, central bankers had little in their armoury, now they do. Curves need to normalise, but we think markets are likely to react first to economic weakness and rate cuts, which should drive yields for all maturities lower.
One of the most important points for next year, and one that could offset the spread widening that we are expecting at some stage, is the anticipated flow of cash out of cash-like products and back into fixed income. With money market fund assets sitting at over $5.8tn, and with much of this in short-dated government bonds, the strong recent performance from credit, coupled with the fall in rates at the short end of the government bond curve, should see a significant move back to higher-yielding alternatives.
With confidence growing that the Fed and other central banks will be cutting rates next year, cash as an asset class will look less appealing and we expect significant inflows to fixed income next year as a result, with this added technical driver playing a very important role in performance.
It is also importation to mention, once again, how unprecedented the rates move has been for fixed income. The US treasury index, which had just produced two consecutive years of negative performance for the first time in 45 years, since the inception of the index in fact, was on track to deliver a third negative year before the recent rally. This has been a huge negative headwind for credit but short of any increased chances of defaults will have simply delayed returns, not extinguished them, and we expect much better performance as government yields stabilise, particularly given the very attractive yields on offer.
There was a very lively debate this year between the PMs as to how and when the economy will weaken and how the markets would react. It is true to say that it was not easy to find consensus on all points, but in many cases, the timing of the anticipated economic changes played a part in this. Ultimately, however there was strong consensus that there is compelling value available in fixed income and that many investors will be able to satisfy all of their investment objectives from the income being offered, and if flows return as we strongly expect they will, this technical driver will only add to the attractiveness of the yields on offer.
Past performance is not a guarantee of future results. Please remember that all investments come with risk. Positive returns, including income, are not guaranteed. Your investment may go down as well as up and you may not get back what you invested.
The views expressed represent the opinions of TwentyFour as at December 4 2023, they may change and may also not be shared by other entities within the Vontobel Group. Any projections, forecasts or estimates contained herein are based on a variety of estimates and assumptions. There can be no assurance that estimates or assumptions regarding future financial performance of countries, markets and/or investments will prove accurate, and actual results may differ materially. The inclusion of projections or forecasts should not be regarded as an indication that TwentyFour or Vontobel considers the projections or forecasts to be reliable predictors of future events, and they should not be relied upon as such. TwentyFour, its affiliates and the individuals associated therewith may (in various capacities) have positions or deal in securities (or related derivatives) identical or similar to those described herein.