Higher… and for how much longer?

The following is an extract from our Q4 Active Insights publication.

For much of 2023, resilience has been something of a watchword in financial markets. Equities have taken comfort from the fact that economic activity and tighter labour markets, particularly in the US, have kept macroeconomic conditions buoyant. Credit spreads have also shown surprising resilience. The yield curve, on the other hand, has been inverted since July 2022 (10-year bonds have been yielding less than two-year bonds), at odds with the dominant market narrative of a soft landing, and definitely at odds with the views of the no landing camp.

The hawks have started to circle

September’s Federal Open Market Committee reiterated what had already been set in motion at the annual symposium of central bankers at Jackson Hole in late August. Namely, that the strength of the US economy would likely trigger the need to keep interest rates high.

Real rates started to rise. Financial markets, which had initially worked on the premise that the effects of monetary tightening would quickly work their way through to the real economy, culminating in a rate peak, followed by a fall in interest rates, became concerned that their original assessment was incorrect. Indeed, investors have now pushed out the timing for rate cuts from the US Federal Reserve (Fed), with the first reduction not fully priced in until the second half of 2024.

Living with higher interest rates

As a result, investors are becoming more convinced that the Western world may have to live with higher interest rates, and for longer than previously thought. How comfortable the economy is with the current level of interest rates is debatable.

As a house, we’re interested in the question: “What will investors be more concerned about going forward – is it high inflation, or low growth?” While there is evidence to suggest that headline inflation appears to be slowing, we haven’t seen enough disinflationary momentum in wages and enough slack developing in the labour market to be confident that inflation is “yesterday’s problem.” The risk is that inflation continues to be embedded in the system even when the economy starts to slow down.

We also continue to probe the widely held belief that any recession will be shallow. Won’t the lagged effect of cumulative tightening mean higher refinancing rates, a pick-up in default rates and depleted household savings ratios, thus making a hard landing more likely? Already we are seeing some deterioration in corporate fundamentals in the US and Europe, while leverage is starting to pick up.

Too many unknowns

For now, we are not seeing any meaningful pick-up in default rates, and in the high-yield space, we believe, we are unlikely to see that until 2025 or 2026. We also believe strong technical demand continues to underpin the high-yield market.

It’s possible that rate stability, coupled with a goldilocks labour market, may mean that we see robust credit demand as we head into the seasonally stronger fourth quarter of 2023. But at this stage, too many unknowns, coupled with heightened geopolitical tensions in the Middle East and elsewhere, make us cautious in our approach.

Investor implications

In terms of investment-grade corporates, while the ratio of upgrades to downgrades still shows a greater percentage of upgrades in the US and Europe, that differential has reduced in the past quarter. Many issuers will start refinancing their fixed-maturity debt in 2024 and 2025, and they will have to absorb higher coupon payments. When we look at the level of credit spreads, we don’t believe that we are sufficiently compensated to take overweight positions in investment-grade credit risk.

As a house, we remain defensive in our outlook for risk assets, given our belief that there will be a recession in the latter stages of 2024. Within that cautious outlook, we remain positive on fixed income. Our conviction will grow, and we will meaningfully increase our appetite for duration, if we see widespread evidence that investors believe the economy can live with higher for longer interest rates.

The above is an extract from our Q4 Active Insights publication.