Developed market central banks have indicated they have reached the peak of the hiking cycle and are now carefully taking the steam out of the ‘higher for longer’ narrative. The global economy has been surprisingly resilient, but cash buffers built up through the pandemic are now winding down, locked-in low rates are rolling off, and – while yields may be lowered by central bank cuts – it remains much more uncertain whether spreads at the lower end of the spectrum will be able to follow. It is hard to see help coming in the form of top-line growth with consumers tightening their belts, facing higher loan payments, greater rewards for saving, and the ill feeling of house prices in Europe and the UK continuing to adjust downwards.
Spreads are fair at best today versus historical averages, but yields are at some of the highest levels since the 2007/08 global financial crisis in parts of the fixed income spectrum – and this, perhaps, provides one area of opportunity. Here, higher yields coupled with historically low cash bond prices will likely be enough to cushion investors from a moderate recession and perhaps even systemic stresses. Indeed, by accessing subordination, complexity and liquidity premia segments of the structured credit market, we believe attractive returns should be available with limited delta to the underlying economy.
Yields are at some of the highest levels since the 2007/08 global financial crisis in parts of the fixed income spectrum – and this, perhaps, provides one area of opportunity.
To add further complication, structural economic trends, globally, may cause some inflation to be stickier than we would like – the climate transition, an ageing population, and the related greying of the developed market workforce, as well as increased defence spending, all point to lofty fiscal spend. Governments will have their hands full balancing public debt that is rising rapidly, with a higher proportion of spending on interest payments. A false step will see the bond market punish fiscal profligacy. However, cutting public services or raising taxes is a notoriously difficult step, particularly in an election year. And it’s not just voter confidence that is required – markets are going to be asked to digest a sea of sovereign new issuance at a time when central banks are also attempting to decompress bloated balance sheets.
The ‘trash’ rally, reversed
Given all of this, it’s no surprise that, in 2024 and beyond, we expect analysis of corporate fundamentals to be a dominant theme. This is in contrast with 2023, where the lower quality component of the market outperformed almost irrespective of underlying fundamentals.
This partly stemmed from investors’ relief that the long-feared hard landing had not materialised but other factors were also at play, not least a lack of new issuance which meant capital competed for whatever opportunities were available. But, this year, with earnings set to disappoint, we expect to see a pick-up in leverage, less comfortable levels of interest coverage and a rise in defaults coupled with lower recovery rates. In short, a reversal of last year’s ‘trash’ rally, with a new set of opportunity for investors positioning themselves in the higher quality part of the market.
For fixed income investors, higher interest rates may restore some discipline to markets – a reminder that you can pay a dividend, but you must pay a coupon. Defaults will rise but not spectacularly so. However, the pain will be compounded by low recovery rates stemming from years of covenant degradation. The new regime of higher rates feels strange and uncomfortable, but really it was the prior time of ultra-low rates and quantitative easing (QE) that was the abnormality.
360°, Q1 2024: Dispersion, disparity, duration
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