Fixed Income Outlook 2024: Staying ahead of the curve

Let's take a closer look at the state of fixed income markets in the past year, and dig into the current and future potential of rates, central banks, investment grade credit, high yield and emerging market debt.

Rates

Interest rates are currently at attractive levels. While rate volatility in 2023 may have created some uncertainty about the right entry moments to add duration, 10-year US treasuries hitting 5% in October has created very attractive levels.

Until the summer of 2023, curves were significantly inverted. However, we expect the post-summer sell-off to reverse and to transition into a broad bull-steepener towards 2024.

What has been priced in?

Markets currently display very moderate inflation expectations, ranging between 2% and 2.5% over both the short and long term in Europe and the US. These expectations haven't changed significantly over the past few months. However, real yields did, with their increase being the main driver behind the rise in interest rates over recent months.

So the market is not pricing stagflation in at all, despite this term being used all too often this year. Quite the opposite: the market is pricing on target inflation expectations with higher real returns. This means that the high interest rates are mainly a reflection of a sell-off in real rates. Hence, as inflation expectations coincide with central bank targets, inflation protection remains attractive. This makes an allocation to inflation-linked bonds a good hedge against one of the risks of being overweight duration, namely, higher inflation expectations.

Economy

If we look at the outlook for the economy, growth risks have usurped inflation risks. This will likely apply downward pressure on policy rates and interest rates across the curve in 2024. The global labour markets have been resilient so far, though several indicators have begun to turn. We expect European employment growth to stall in the next few months, and it's important to note that the labour market is not a leading cycle indicator.

Inflation is cooling rapidly, with current Eurozone inflation rates already falling below 3%. Although we may see some basis-effect driven volatility in inflation prints, the overall picture is clear. There is also notable dispersion between countries, with Belgium and the Netherlands' current annual inflation figures printing negatively.

The consumer, flush with cash from various fiscal packages, is experiencing a reduction in their real disposable income. Personal savings are also dwindling, while consumer credit growth has turned negative and credit card delinquencies have risen.

Global leading indicators for both the manufacturing and service sectors are pivoting towards negative values. Similarly, business leaders' surveys are becoming less positive. Economies are currently riding on their previous positive momentum but will soon feel the impact of slowing demand and tightening financial conditions, which will likely result in a swift narrative shift in markets. The impact on rates in 2024 is expected to be significant.

Central banks

Central banks have maintained a tightening mode for almost two years. Despite this, the global economies have remained resilient for longer than expected. This resilience can be attributed to three factors.

First, fiscal stimulus at unprecedented levels, with the US having reached fiscal deficits of 18% during the first quarter of 2021 and still expected to exceed a 5% deficit for the following two years. We have seen similar trends in other countries, albeit less excessive. For instance, France is predicted to have deficits between 4% and 5% of GDP for the coming two years, while Germany is expected to be more conservative. Hence, fiscal stimulus has been offsetting some of the tightening effects of monetary policy, although different parts of the economy may be affected differently by the fiscal excess and the monetary constraints.

Second, monetary policy operates with a lag, so it may well be that much of the tightening effects are yet to be felt in 2024. For example, in the Eurozone, we are already witnessing the impact of monetary tightening due to interest rate hikes and a significant balance sheet reduction by the ECB, which shrunk its balance sheet from almost 70% of GDP to 50%. This trend will likely continue in 2024 and keep exerting a considerable tightening effect. This is expected to continue in 2024 and will continue to have an important tightening effect.

As the near-zero policy rates were clearly structurally accommodative, the truly neutral (real) policy rate of the moment remains unclear. This debate merits a separate discussion. Yet, it can be assumed that during the initial rounds of hikes, rates remained in an accommodating territory. Hence, the real monetary tightening has only started in recent times.

Central banks have mostly maintained interest rates near zero between 2009 and 2021, with the years just before COVID started being the only exception. Since the end of the inflation problems in the 1980s, central banks have not really been troubled by inflation, even during a decade with near-zero policy rates. This might have created the illusion that Central Banks can perpetually maintain accommodative stances without fearing an upside inflation problem. On the contrary, they were actually fearing the opposite. However, the recent past's inflation spike has punctured this illusion. Central banks are unlikely to revert to structurally low policy rates. In fact, it's likely that they will administer monetary policy on a less aggressive basis, spacing out periods at zero. Future policy rates are expected to fluctuate between the current policy rates and near-zero, depending on the weight of any future economic slow down. This provides another perspective on why the current rates are high and therefore appealing.

Investment Grade Credit

Investment grade credit issuers remain in a very strong position, backed by healthy margins, a large cash reserve on their balance sheets, and robust debt maturity profiles. This places them in a strong position to withstand potential economic slowdowns. Their diversified business models, in terms of both products and geographical reach, make them highly resilient.

Since the war in Ukraine, the credit spreads on Euro-denominated bonds have broadened compared to many other developed markets like the US. This makes Euro credit even more appealing. The additional spread, or carry, offers another layer of protection against potential spread widening in the event of a downturn. The overall creditworthiness of investment-grade credit issuers is on an upward trajectory, evidenced by a greater number of rating upgrades than downgrades. These factors, combined with the added carry and solid underlying businesses, make this asset class a clear overweight.

High Yield

High yield credit spreads are currently compelling, but a tightening is not expected for now. The 7% current yield in Euro offers a healthy buffer against expected defaults. If these spreads widen due to an economic slowdown, this asset class would clearly present attractive entry points further into 2024. Leverage levels in high-quality high yield credits (BBs) have been reduced compared to the past few years, making these businesses better prepared for a potential slowdown. Considering these factors, our current stance on high yield credit remains neutral. However, any spread widening in 2024 could spawn opportunities to increase our investments.

Emerging markets local currency

Despite a 10% return YTD in EUR terms, we believe all positive elements for the asset class remain well in place.

EM FX should be well supported by the careful stance of emerging markets central banks. They have been well in advance of developed markets central banks on the way up. They take into considerations the external conditions, including the impact of lower rates on the currency, on the way down. By doing so, they manage to preserve sufficiently large real rates buffers. Less USD strength, resulting from lower/peaking FED funds rates, are a tailwind for emerging market currencies. The still above 8.50% current yield in Euro offers a large protection against higher rates and 70bp carry on a monthly basis. Driven by very attractive real nominal rates across emerging markets, in a context of lower global rates, we expect duration to generate a positive return as well. All in all, we believe 2024 will be a repeat of 2023 for local currency emerging markets.

Positioning

If we look at our overall positioning, we can conclude that carry has re-emerged in the bond market. We recommend bolstering duration on weakness and moving to an overweight position. We also keep our overweight in investment grade credit. This asset class features a shorter duration than government bonds and provides an appealing additional carry due to its spread — which is still attractive. When it comes to high-yield credit, the current standing is neutral, but a downturn could present opportunities to increase investments. Certain asset classes offer enticing yields which provide substantial protection against other risks, such as currency losses or credit losses. Emerging market local currency debt is a good example, offering a 9% yield. With a predicted reduction in US yields, the underlying currencies should also be largely safeguarded.

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