Bonds in brief: making sense of the macro - December issue

Marco Giordano, Investment Director
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Welcome to December's “Bonds in brief”, our monthly assessment of risks and opportunities within bond markets. 

Key points

  • 2023 ended with a bang, as fixed income markets extended their rally into December amid increasing confidence that major central banks have reached the end of their rate-hiking cycles and that cuts are forthcoming in 2024. 
  • Bond indices ended the year with positive returns across government and credit sectors, and the fourth quarter saw the strongest quarterly performance for many sectors since the 1980s. 
  • While the move in bond markets has been extraordinary, the economic data remains mixed and will require close monitoring in the months to come, to understand whether policymakers are avoiding unnecessary overtightening or are, in fact, entrenching higher inflation in economies.

What are we watching? 

  • Geopolitical tensions continue to escalate in the Middle East. Iran-backed Houthi rebels attacked commercial ships travelling through the Red Sea during December. Meanwhile, Iran deployed a warship to the Red Sea in early January, a move intended to challenge US forces in the key trade route and that may embolden the Houthi militants that have disrupted shipping in the waterway to protest Israel’s invasion of Gaza. As the Red Sea constitutes a choke point in maritime trade, several shipping companies have paused or diverted cargo routes to circumnavigate Africa instead. This is causing shipping times and costs to increase, although we remain far from the extreme freight prices seen in 2021 and 2022.
  • Unexpected reacceleration. Following the rally in the final two months of 2023, has the market got ahead of itself by pricing in a soft landing/Goldilocks outcome with aggressive rate cuts from as early as the spring? Early trading in January suggests investors are expecting a very narrow set of outcomes, which could be derailed by upward surprises in the economic cycle, such as continued consumer resilience, strong labour markets and loosening financial conditions. While disinflation is likely to continue, we find ourselves in an uncertain environment, and bond exuberance can suddenly shift to nervousness should we not see a return to the 2% inflation target.
  • Quantitative tightening (QT), and the debate around its ending, is likely to be a hot topic in the months ahead. While US Federal Reserve Chair Jerome Powell had previously indicated QT could continue after rate cuts, there has been speculation about whether QT should, in fact, end before cuts are initiated to ensure stability in the financial system by not depriving market participants of reserves along the way. The pivot to policy accommodation coincident with potentially reaccelerating growth proves to us we really have entered an uncomfortable and less predictable, although by no means less exciting, market regime.

Where are the opportunities? 

  • We continue to see opportunities in higher-quality total return strategies, which are less constrained by benchmarks, to help navigate this late-cycle stage.
  • In our view, core fixed income, and particularly credit, strategies appear increasingly attractive from both an income and capital protection perspective. They offer a combination of yield and, unlike cash, significant upside potential in a risk-off environment.
  • We think high-yield and emerging markets debt remain attractive, but we expect continued volatility along with geopolitical risk. High-yield fundamentals may worsen as lagged policy effects work their way through the economy, but corporate earnings have remained resilient so far. Notably, in Europe, we have not seen the same leverage buildup in the high-yield market as we saw in previous cycles.

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