Economic winds are changing. Even if the inflation fight in developed markets has not yet been won, a highly inverted yield curve, weakening consumer demand, and some looming credit market tremors are pointing towards clouds on the horizon. This requires us to provide you with a blueprint to navigate this dynamic fixed income landscape.
MAPPING THE RATE LANDSCAPE
In line with the expected turn in the global economic cycle, we favour a neutral duration stance but with a bias towards going long. We believe it is appropriate to add duration on interest rate weakness or a sudden sharp turn in the economic cycle.
This strategy stems from a slowdown in the global manufacturing sector, driven by subdued demand which threatens to seep into the services sector. As the services sector is very labour-intensive, a cycle of weakening services demand might lead to weakening employment demand. Consequently, a self-reinforcing cycle of demand contraction and unemployment increases might occur.
Meanwhile, inflation remains uncomfortably high. The unprecedented coordination between monetary and fiscal policy following the Covid shock has fuelled its surge. As the ECB strives to normalise policy amidst continued fiscal expansion, returning inflation back to the 2% target remains a daunting task. In the United States, current inflation expectations sit slightly above 2% across the curve. In Europe, inflation breakevens are relatively close to US levels but much higher than their historical levels before the Covid shock when Europe suffered from deflationary risks. Consequently, on a relative basis, US inflation expectations appear more enticing. Yet, also in Europe, there is value given the discrepancy between breakeven levels and the inflation coupon accrual, particularly at the shorter end.
The economic environment in peripheral economies remains very resilient from a European perspective. In general, over the last quarters, Europe moved from a broad-based, albeit light, economic expansion to one of only limited pockets of economic growth. Europe’s peripheral countries, especially those with tourism-driven service sectors, are under the limelight. In contrast, countries grappling with industry-driven growth models will continue to struggle to adapt their economies to the energy cost mix, with Germany, the Eurozone’s powerhouse, in the spotlight. Despite current excess supply conditions, possibly due to hoarding practices and a mild winter, the energy crisis is not over, and a potential shift in Q4 could further constrain growth and reignite inflationary pressures.
The sovereign credit risk landscape is also changing, with rating agencies placing increased emphasis on fiscal sustainability, leading to the initiation of rating revisions in Europe. The ECB is close to the end of its tightening cycle but is not yet finished as they will have to remain restrictive for longer in order to bring inflation back to target. Over the coming months, we will see reduced liquidity from targeted longer-term refinancing operations (TLTRO), another rate hike, and the full cessation of the APP reinvestment programme. These changes will continue to apply pressure on financial conditions and financial markets in the Eurozone, underlining the need for prudent investment decision-making and strategic security selection.
EXPECTED STEEPENING OF THE YIELD CURVE
A key area that has been grabbing attention lately is the inversion of many interest rate curves across developed markets, a trend that has been underway since the last quarter of 2022. This is largely the result of a mix of an anticipated economic downturn and the closing chapter of the monetary policy’s tightening cycle. The implications are twofold: the short end of the curve aligns with elevated policy rates, while the longer end reflects lower future policy rates, as current elevated policy rates are considered an exception. This presents an opportune moment for investors to board the ‘steepener’ train.
On the flip side, the credit market could prove less forgiving. Companies boasting strong balance sheets and liquid bonds are likely to weather the storm better than those on shaky financial ground. Given the expected economic slowdown and the tight financial conditions, we prefer investment-grade over high-yield bonds. Despite the bearish sentiment among credit investors, we anticipate a brighter horizon once the full economic impact of Central Bank tightening unravels and a consensus on terminal rates emerges. Until then, brace for continued volatility with the consolation that current yields offer a buffer against potential market weakness.
THE SUSTAINABILITY-LINKED DILEMMA
The world of sustainable bonds can be divided into two main categories: use-of-proceeds bonds and sustainability-linked bonds.
The former refers to bonds whose proceeds are earmarked to finance specific environmentally or socially focused initiatives and are often known as green or social bonds. In contrast, sustainability-linked bonds carry an intriguing twist. While the funds raised are not tied to specific projects and may be used for general corporate purposes, the interest rate or “coupon” these bonds pay can increase if the issuer fails to meet certain sustainability Key Performance Indicators. Enel, the Italian energy company, broke ground in this field back in 2019, promising a 15-basis-point hike in their coupon if they fell short of their renewable energy targets.
However, the sustainability-linked bonds sector, despite promising beginnings, has encountered several obstacles. Regulatory issues and ambiguity over their place in banks’ capital structures have posed significant hurdles. Moreover, the model’s effectiveness is being questioned, as there is concern that the potential coupon increase might not be enough to genuinely spur companies towards sustainable behaviour. Thus, the narrative around sustainability-linked bonds is evolving into a more intricate tale than many had initially predicted.
CENTRAL BANK MANEUVERS IN EMERGING MARKET ECONOMIES
Finally, we observe that emerging market (EM) central banks have effectively created a robust rate buffer, nearing their peak rates. Fiscal policies and the anchoring of long-term inflation expectations will dictate the start of any policy reversal. We anticipate that most EM central banks will pause, awaiting signals from the U.S. Federal Reserve. These high (real) policy rates should provide some support for their currencies. This has us expecting neutral to mildly positive currency returns for the rest of the year.
In the context of yields, they remain appealing in absolute terms. The bond may see duration gains as global growth is projected to slow down. The yield curve is expected to steepen, suggesting that maintaining current duration but shifting from wings to the belly of the curve (8-12 years maturity) could be advantageous for investors. While the high yield and investment-grade spread may seem attractive, investors should be mindful of potential shifts towards quality investments. In the complex global fixed-income markets, it pays to remain adaptable and patient, understanding that opportunities exist for those prepared to seize them.
