Shaken, not stirred

Mr Bond, we have been expecting you 

The quarter just ended was an incredibly good one for fixed income investors. A ranking of quarterly total returns for bond indices provided by ICE/Bank of America shows that Q3 2024 was the second strongest quarter of 49 quarterly observations since Q3 2012. For global credit it was the third best quarter and for US high yield it was the fourth best. It was only the third quarter since the Federal Reserve started to tighten policy that US Treasuries outperformed cash – and the same for European government bonds against euro cash returns. The 12-month return ending September 2024 was the best 12-month period for global credit (investment grade) returns over that same period.

With cash rates falling and bond yields still having some room to decline as the easing cycle continues, fixed income remains interesting for investors. Of course, if you are concerned about a US recession or an escalation of the Middle East conflict, bonds look interesting. I have said for some time that 10-year US Treasury yields are in a fair value range and in recent weeks have stabilised in that 3.75%-4.0% range. But they can still go lower if the market has a risk-off episode.

More neutral 

Sticking to the core cyclical outlook – characterised by the expectation of a soft landing – it would be logical to think the best returns from fixed income markets are behind us. Recent performance has been driven by a big re-pricing of interest rate expectations relative to a few months ago. The implied end-2025 three-month US dollar interest rate (taken from futures market pricing) has declined from 4.7% at the end of April to 3% today. Without clear signs of a recession, another such decline in rate expectations is very unlikely. The yield on the benchmark 10-year Treasury would need to decline to around 3% to get an equivalent total return. I get a sense that investors have shifted to a more neutral stance on rates.

Pushbacks

It has been interesting discussing bond markets with clients in the last couple of weeks. Whether or not investors were able to participate in the bond rally or not, there seems to be some level of discomfort at what is priced in today. My reading of the market is that rate expectations are consistent with a soft landing and with central bank interest rates going back to neutral in 2025. The pushback to that scenario has two main themes. The first is that we cannot rule out a recession – although no-one has a clear view on what might cause one. There are concerns about the stock market being in a bubble which might burst. There are concerns about credit conditions deteriorating because of “irrational exuberance” – an upturn in lower quality borrowing as rates come down. There are also concerns about a slow-burn recession as the labour market gradually weakens and that the weakness in the manufacturing sector pervades the broader economy. This week we got the September Institute of Supply Management manufacturing index which has been below 50 in 22 out of the last 23 months. Typically, this would suggest broader economic contraction in the US.

Trump 

The second theme regarding the rates outlook concerns the prospect of an inflationary Donald Trump second presidency and fears of a US fiscal crisis. I wrote about that last week and apart from some potential increase in the risk premium at the long end of the Treasury curve, the fiscal outlook is hardly a theme dominating investment flows today. Yet it is a theme amongst clients, particularly in Europe.

Oil still important 

Human nature tends to worry about what can go wrong. The intensification of the conflict in the Middle East tells us is that something can come along to upset the apple cart. This is something that could disturb rate expectations, through the potential impact on growth and inflation, should the global oil supply chain be affected. Oil markets are starting to reflect the potential for Israel to attack Iran’s oil facilities. Brent crude December futures prices have jumped $8 per barrel from their recent low (although so far, the curve is quite flat, so oil traders are not necessarily pricing in a long-lasting impact on prices). Oil is less important than it used to be, but we saw in 2022 what an energy price shock can do to global inflation and growth.

On the sidelines 

One client said to me that “we are in a wait-and-see market”. Waiting to see if either fiscal-induced inflation or a recession is a more likely scenario in the US, than the Goldilocks one which is currently priced in. Waiting to see the result of the US election, what happens with Iran and Israel, how Europe’s political landscape evolves and whether the big policy announcements from China will break the downward debt-deflation spiral. On that we are sceptical and, given the huge increase in equity prices in China since the monetary easing, the value opportunity has gone anyway.

Credit is rewarding 

Wait and see and clip the coupon. If yields are going to be anchored to the monetary path that reflects the consensus, then the extra yield from credit should be harvested. In the US high yield market, defaults remain low so the yields on offer still more than compensate for potential losses, in our view. In high grade credit, why not go for the additional 110-120 basis points (bp) of yield in the lower-rated part of the US investment grade market, or the 105bp of additional bond yield relative to swaps in the euro market. An allocation to high yield brings an all-in yield at the index level of 6% for euro and 7% for US dollars. For the equity investor, I just have a feeling that Q3 earnings are going to be good for technology stocks with commentators seeming to be excited about the new Apple iPhone and Nvidia’s microchip pipeline.

A typical client Q&A 

Will the US suffer a recession? Who knows. It can happen quickly but balance sheets are mostly healthy, unemployment is low and there is not going to be any fiscal tightening. So this remains a positive environment for equities and credit. Will China’s policy announcements restore growth and confidence? Well, the equity market bounced but I am not sure we will get the follow through. It is not clear yet that the policy steps will be enough to restore the health of balance sheets. Should we worry about the US deficit and debt level? No, not until there are signs of a buyers’ strike, meaning weak auctions or a declining dollar suggesting a loss of international confidence. But secretly, a fiscal-induced Treasury market collapse is an extremely low probability. And if there is, it would not just be the Treasury market you would want to avoid as credit spreads would widen and equities would get hit by the uncertainty over how fiscal retrenchment would impact on growth. And, if the US sneezes, the rest of the world will catch a cold. Are stock markets overvalued? The current 12-month forward price-to-earnings ratio for the S&P 500 is about 1.4 standard deviations above its three-year average. Other indices, like the Nasdaq, Euro Stoxx and the UK mid-cap index, are close to the average of the last three years. The big-cap tech stocks trade on much higher valuations, but they are not unusually high relative to their history. Apple has a price-to-earnings ratio of 34 times but is extremely profitable, with a Q2 operating margin of 30% and return on equity of 160%. If the soft landing scenario is valid, then given the earnings backdrop and the amount of investor liquidity in markets (money market funds, private credit flows), then it is hard to be bearish on stocks just now.

Income and quality

There are a lot of risks. Timing market moves that might respond to these risks is difficult. Credit default swaps indices, the VIX equity volatility index and US break-even inflation rates have all moved higher in the last couple of weeks. It is not a big call to suggest that volatility will be higher in the remainder of the year given all the geopolitical uncertainties. Income from bonds and quality exposure in equity markets are sensible investment themes in such an environment.