Why the macro outlook is tilted in fixed income’s favour

The current year has been a good one for financial markets. Performance dispersion has been higher than in the recent past, but it is fair to say most asset classes have rewarded those investors who thought the best days for holding cash and ultra short-term government bonds were behind us.

Government bonds have been volatile as investors’ expectations around the timing and size of interest rate cuts have swung sharply through the year. The 10-year US Treasury has delivered a total return of 0.3% year-to-date (YTD), which while still positive is lower than the yield on offer at the beginning of 2024 as investors have priced in a slower and less aggressive rate cutting cycle than previously anticipated. The return on the equivalent German Bund has been almost flat, while UK Gilts have been the odd one out with a negative total return of almost 2%.

Credit has outperformed. Investment grade (IG) non-financial corporate bonds have returned around 3% YTD in USD terms, with the EUR and GBP equivalents up 3.7% and 1.1% respectively.¹  Financials have outpaced corporates, with IG financials returning 4.9%, 4.7% and 4.4% in USD, EUR and GBP respectively. ²  If we look at lower rated cohorts, high yield (HY) indices have had a solid year as well, with returns in the region of 7.5% YTD, while bank Contingent Convertible (CoCo) bonds have delivered a notable 11.1%.

European asset-backed securities (ABS) investors are enjoying a day in the sun as well. With the largely floating rate nature of ABS keeping the asset class somewhat immune from the swings in rate cut expectations, volatility has been lower than in more mainstream and duration-rich markets. From the 3.5% YTD returns in AAA Dutch Prime residential mortgage-backed securities (RMBS) to the 19% in single-B rated European collateralised loan obligations (CLOs),³  with numerous outcomes in between depending on collateral and rating, ABS has delivered some of the best risk-adjusted returns in fixed income so far this year.

Now that credit spreads are firmly below their long-term averages, there is something of a “what next?” narrative emerging. We think what’s next is a period where carry will be the main engine of total returns. Given the elevated yields on offer, along with the expectation that inflation will come back to target, we think fixed income investors can target a level of real return that was extremely difficult to achieve in the previous cycle. Volatility will likely rear its ugly head from time to time, though as we will detail below, in our base case we expect these episodes to be short-lived and relatively shallow – in other words, a potential buying opportunity.

Hard landing fears are fading

It was only a few weeks ago that some market commentators were calling for an emergency intra-meeting rate cut from the Federal Reserve (Fed). And it was only a few weeks before that that some others were debating whether monetary policy was in fact in restrictive territory. After the broad sell-off in early August sparked by an unexpected jump in US unemployment, as well as more general evidence that the labour market was cooling off, the stakes for the Fed’s September meeting were as high as they had been for a long time.

Along with cutting 50 basis points (bp) on September 18, the Fed’s message was very important. First, the base case is not only that the US economy will avoid a recession, but that it will not even come close to one. Second, the labour market has weakened to a point where the Fed thinks it is prudent to start cutting rates; it was as clear on this point as it was on the fact that there is no need to cut in a hurry as the economy is doing well. Third, and most importantly for asset allocation purposes, the Fed’s suggestion was that, should growth or unemployment take a turn for the worse, it will act decisively and in size to steer the economy back towards the base case.

For investors, this last point refers to the famous “Fed put”. Given that the economy is decelerating due to monetary policy rates being in restrictive territory, the Fed has the medicine the economy and markets would need if conditions deteriorate from here, i.e. it can cut rates faster. Market participants therefore have some degree of confidence that if there is stress in the market and asset prices fall markedly, the Fed would act. For fixed income investors, the implication is that episodes of spread widening should very quickly draw buyers, thereby limiting the extent of such episodes or potentially even preventing them from happening at all.

Eurozone and UK growth are on the right path

Growth in the Eurozone and the UK in 2023 was a pale 0.4%, with a particularly weak second half of the year seeing the UK and certain Eurozone countries experiencing a technical recession. The data has been far more solid in 2024, and that is reflected in the outlook; the Bloomberg consensus of economic forecasters is for growth of 0.7% and 1.3% in the Eurozone for 2024 and 2025, respectively, and 1.1% and 1.4% for the UK. While far from spectacular, both are moving away from recession with growth trending up towards the potential rate. 

The exception has been Germany. The energy crisis resulting from Russia’s invasion of Ukraine has left more scars than in other countries given the importance of industry in the economy. Real quarter-on-quarter growth has been zero or negative in five out of ten quarters since 2022. It looks likely that 2024 will be another year of negative real growth, with a recovery in 2025 still elusive. Delinquencies in German consumer ABS transactions have seen worse performance than in other countries in Europe, as the economic situation takes a toll on people’s ability to pay their loans. This is not a systemic issue for the Eurozone in our view, but there is little hope for a sharp recovery in the bloc’s largest economy. The rest of the Eurozone is fairing much better, with Spain’s 2.7% Bloomberg consensus growth forecast for 2024 at the top of the table.

One of the starker differences between Europe and the US is in the savings ratio – the percentage of disposable income consumers put aside each month. In both the Eurozone and the UK the savings ratio is comfortably above pre-pandemic levels, at 15% and 10% respectively. By contrast, the US savings ratio at just under 5% is now comfortably below its pre-pandemic level; US consumers have less of a cushion if conditions deteriorate more than expected. As fixed income investors we are willing to sacrifice potential growth for safety; traditionally the performance of credit doesn’t quite match equities in bull markets, but it tends to suffer far less when market sentiment turns. European consumers are making a similar trade-off. More savings means less chance of stress among borrowers if the economy weakens, and less chance of non-performing loans on banks’ balance sheets, which mitigates the negative impact if an economy does slide towards recession (which is not our base case for the Eurozone or the UK).

Cash on the sidelines is unprecedentedly high

There is no single accurate measure of cash on the sidelines at any given point in time, but it is effectively the monies investors are sitting on with the intention of deploying them at some stage in other assets such as credit, longer dated government bonds or equities, among others. While we can only get a partial picture, we do believe the vast majority of indicators are saying the same thing: there are vast amounts of monies sitting in short dated, ultra safe assets.

One piece of data that is often cited in this regard is money market fund balances in the US. There is currently an estimated $6.4tr sat in said funds, which is an all-time high. Historically, assets under management (AUM) in these funds are correlated with nominal GDP, with the caveat that they tend to grow more than nominal GDP would imply in times of stress. This is what happened in 2001, 2009 and 2020.

Since late 2022, however, there has been a steep jump in AUM in money market funds resulting in an increase of close to $2tr in the last 24 months. There is more than one reason for this development, but short term rates moving significantly higher was certainly an important factor in making these investments more attractive. It makes sense that once the expected return of these funds declines in line with short term rates moving down, then at least some of that money will seek a home in higher yielding asset classes.

That is the “stock” data, but the “flow” data is also informative. Taking euro assets as an example, flows this year in both IG and HY bond funds have increased markedly compared to last year according to figures from JP Morgan, and the trend has strengthened in the last few months. There is evidence that flows are gathering speed in other sectors as well. We think this trend will accelerate as central banks continue cutting rates and the attractiveness of cash diminishes. The wave of money out of cash has likely only just begun in our view.

More anecdotally, we have seen clear evidence of cash on the sidelines when participating in new bond issues. Primary market activity in recent months has typically seen initial price guidance tightened by 50bp or more, and with order books several times oversubscribed. Gone are the days of bonds trading up quickly in the secondary market because investors have been offered a healthy new issue premium to participate. However, that does not deter portfolio managers who see their cash balances increase every time they get their daily inflows/outflows data.

Under these circumstances, we think the chances of a sustained sell-off in spread products looks remote as investors are willing and able to buy the dip.

Corporate and bank fundamentals look solid

The fact that spreads are below their long-term averages is hardly surprising. Default rates have remained contained and the financial health of companies and banks is not only generally good but improving for the most part. Western European IG bonds have seen more than four rating upgrades for every downgrade in 2024, according to Moody’s data. The figure is close to three upgrades for every downgrade in the US. Trends in HY have not been as rosy, which is to be expected when growth decelerates, with the upgrade-downgrade ratio in European HY at virtually one-for-one while in the US there have been slightly more downgrades than upgrades YTD.

Default rates in HY bonds globally are currently in the region of 3% globally, according to Moody’s. They have increased post-Covid but only to a level around their long-term averages. In addition, there are signs that we might be near the peak for the time being. Default rates in leveraged loans have been somewhat higher as ratings in that market are lower on average than in HY, but this has not translated into stress in CLOs (which are structured around portfolios of leveraged loans) with European 2.0 CLOs, i.e. those issued post-2008, continuing to show no losses of principal.

In our view, banks are in remarkable shape from a credit perspective. In Europe, capital levels are at the highest of the last 15 years while non-performing loans have only risen mildly from the lows across the same period. These positive developments have been the result of stringent regulation, changes in banks’ business models and, more recently, the addition of higher margins to the mix. This is not only important for bank bond investors, but also for the economy at large. Banks are the channel through which monetary policy is implemented and borrowing occurs (or doesn’t occur). Having a strong banking sector that is both willing and able to lend is a key ingredient for a low probability of a hard landing and for limiting the impact of a downturn. 

Portfolios should favour carry over capital gain

Our base case of no recession, near-potential growth, inflation under control, and central banks cutting rates in a slower fashion compared to previous cycles would be a benign environment for fixed income, both for credit and government bonds. A decent macro picture should limit widening pressure on spreads in a sell-off, while the gravitational pull of successive rate cuts should act as a ceiling to how high government bond yields can go. At the same time, given where government bonds yields are, we think they provide ample downside mitigation in the non-base case of a hard landing.

When it comes to positioning, if we throw in spreads that are below their long-term averages and the fact that curves are already inverted, along with the extremely strong technical and flows picture, we think portfolios should be weighted towards collecting carry rather than seeking large capital gains. In asset allocation speak, this means targeting duration at a neutral level, and having exposure to government bonds but overweighting spread products, while keeping credit quality high. Such an asset mix should allow for healthy real returns, and a flexible and liquid portfolio to take advantage of sell-offs while keeping volatility in check.

What are the risks to our base case?

It is important to analyse what other scenarios are plausible. Broadly speaking, we see two alternative scenarios worth examining – “no landing” and “hard landing”. 

A “no landing” scenario would see the US economy continue to grow strongly with little disturbance in labour markets. While this would be good news for spreads and the global economy, it would call into question the running assumption that interest rates are currently in very restrictive territory. The US terminal rate (the lowest rate the Fed will cut to in a given cycle) could therefore be higher than the long-term median base rate of around 3% shown in the Fed’s latest “dot plot” forecast (markets are currently pricing a terminal rate of around 3.4%), which should limit expectations of capital gains from government bonds. Given the elevated yields on offer and the fact we think spreads will be resilient, portfolios broadly aligned with the base case positioning above should still provide an attractive return in this scenario. Were this scenario to take hold, the sensible change would be to reduce the duration position back to underweight.

A “hard landing" scenario would see US growth decelerating quickly to a much worse level than expected, leading to a marked rise in unemployment and eventually a recession that would likely drag Europe and the UK down as well. In this scenario, we would expect to see spreads underperform and government bonds rally as additional rate cuts were priced in. The sensible change to positioning would be larger than under the “no landing” scenario, and would entail a reduction in credit risk and an increase in duration. This could be done by reducing the credit allocation and upping the government bond allocation, though a similar outcome could be achieved by reducing the credit spread duration of the credit holdings while extending duration in the government bond holdings. Valuations would play a role in determining exactly what method is most appropriate, but in all cases portfolio liquidity would be key to making the change quickly. In our view, that liquidity needs to be built and held now rather than in the middle of a recession.

The probability attached to each of these non-base case scenarios has not been static through the year. We think the probability of a “hard landing” for the global economy has decreased in the last few weeks, for two reasons. First, the Fed’s 50bp rate cut is a strong signal that should economic conditions deteriorate more than expected, the Fed will act more aggressively without hesitation. This reduces the probability of an accident. Second, for the first time since its self-inflicted property market crash, China has come out with a coordinated plan to address some of the confidence and housing market issues in the country. This will be a long process even if it succeeds, but we do think the “black swan” event of an even worse downturn in China is lower than when that plan was announced.

As a result, either our base case of a softish landing or the “no landing” scenario has become more likely, though in our view it is too early to tell which. The latest US labour market report for September was very strong and growth indicators have also been better than expected, which arguably favours the “no landing” scenario, but we await further labour market data to confirm this.

Targeting carry and collecting yields

In our view, the current conditions in fixed income are likely to provide attractive risk-adjusted real income for investors in the medium term. 

Given the current macro environment, we think a portfolio with neutral duration, more good quality credit than government bonds, and enough liquidity, should perform positively. The most damaging alternative scenario compared to this base case positioning would be a “hard landing”. The probability of this scenario has been reduced by recent macro developments, especially the Fed’s actions and assessment of the economy in September and China’s more comprehensive response to its economic problems. However, we remain attentive to signs of further weakness and believe holding adequate liquidity today is necessary for making changes quickly if conditions do deteriorate beyond our base case. It is also worth mentioning we think the carry provided by these more liquid assets is more than adequate to compensate investors, in stark contrast to the previous cycle.

In the meantime, we think fixed income investors should be happy to target carry and collect yields, which remain high relative to history.

1.  ICE BofA Indices, TwentyFour, 28 October 2024.

2. ICE BofA Indices, TwentyFour, 28 October 2024.

3. Barclays, Palmer Square CLO Indices, TwentyFour, 28 October 2024.