Fixed Income Monthly Report - December 2023
Preview of our monthly publication with macro themes and single bond ideas
Every month, we publish the Fixed Income Monthly report. The report is a synthesis of the Ashenden’s team view on Fixed Income, pursuing a global approach through the full spectrum of the asset class and providing bond picks. We range from Investment Grade bonds to High Yields & Emerging Markets.
In the report we disclose our bond model portfolio (6 years track record) with more than 60 individual names. We include new single bond ideas, switches, new entries and exits.
All this is corroborated by a bottom-up analysis for each single position (new and old) and merged with a top-down consideration so to include the key market drivers.
This is one of the research piece our team produces internally. The intent of the report is to support wealth managers/asset managers in their decision and allocation process.
Underlying you can find a summary of what you can find inside this report.
December 2023 edition
The “soft landing” narrative is trending again
November has been an exceptionally bullish month, with stocks and bonds surging amid strong inflows. Everything from Tech stocks to junk-rated company debt raised after an encouraging inflation report. This reinforced bets that the Federal Reserve can achieve a soft landing by cooling the economy without pushing it into a deep recession.
The S&P 500 was up 8.8% last month and the Nasdaq Composite climbed 10.7%. While the yield on the benchmark 10-year Treasury note is down more than 60bps – a substantial move.
Large institutionals and funds increased the equity allocations over the last month, reversing from the weaker positioning in Q3 in an extensive short covering move, spurring a strong rally. Combined with year-end seasonality, the surge in institutional flows could push equities more, leaving less room for upside next year. Surprisingly, November also saw retail investor participation to their highest levels since Mar 2022. A sign of an euphoric market.
US bonds had their strongest monthly gains since 1985 due to increasing confidence that the Fed will reduce interest rates next year, sparking a sharp recovery from a sell-off earlier in October. The interest rate futures now fully anticipate a 0.25% rates cut by the Fed in May. This marks a notable shift from sentiment in mid-October, when the consensus was that a rate cut was unlikely to occur before mid-2024.
We believe it will be a choppy ride. While last month’s rise in yields probably marked the peak for now, there may be more bumps ahead for the bond market. That is because central bankers aren’t likely to signal a pivot to easing anytime soon as the economy still has to show a weakening.
How much of this Goldilocks?
Markets remain completely focused on the macro outlook where few factors are contributing to a resilient economy: 1) household and corporate balance sheets are still strong; 2) excess savings accumulated around the pandemic are running out, but not yet; 3) housing is by far the most interest rate sensitive part of GDP, but its share is much lower than in past cycles: 4) internally generated cash flow covers payouts and capex in the aggregate for the S&P 500 as well as for the median company. The corporate need for net new debt issuance remains very low; 5) last but not least, overall, corporate profit margins remained resilient.
Slowing inflation and a solid labour market are supporting confidence and preventing further decline, but the pace of improvement in the inflation picture has been frustratingly low. Inflation expectations for the next 12 months fell to 5.7%, marking the 6th month in which the measure printed between 5.7% and 5.9%. This is the lowest level since October 2020 but still inconsistent with the Fed's 2% target and indicative of a loss of disinflationary momentum.
So, all in all, recession expectations receded and consumers have not put off their big holiday shopping plans. But even if the Black Friday shopping week was solid, there was a significative increase in “buy now, pay later“ activity, meaning that consumers are probably stretching their budgets further.
This strong economic growth cycle was able to withstand an especially aggressive monetary tightening cycle. But in our view, the recession in the US and Europe was just delayed and won’t be avoided. Developed economies remain on a recessionary path unless monetary policy eases significantly. Excess household savings supported the US consumers this year but are close to be exhausted.
But most of investors seem to ignore this possibility, as we see downside protection is cheap.
Credit: investors chasing markets
As disinflation and labour markets stayed the course in a "Goldilocks" zone, which in turn allowed Fed Chair Powell to whisper we are close to the end of the hiking campaign. And with the help of a healthy dose of Treasury supply relief, there is a belief that the rates headwind for equities is behind us.
Although the rally looks exhausted and technicals are stretched, overall equity positioning is only back to neutral and dry powder remains, given high cash levels. So, while markets may take a breather, we see potential for investors to chase the market higher if fundamentals hold into 2024. The narrative around “landing zones” will drive the direction of credit performance through the 2024. In 2023 credit performed well, so far, driven by a strong technical backdrop and a ‘slow motion’ fundamental deterioration.
In 2024 we expect the nearing maturity wall to be one of the factors to consider, as it should translate into more prepayments (for strong credits) and defaults (for weaker credits). The period of easy money and strong business conditions where companies were able to refinance at low rates and benefited from boosted revenues and profit margins has ended.
Against this backdrop, Investment Grade bonds should fare better as the increase in funding costs is more manageable for those issuers given lower overall debt levels. While there is scope for spreads to widen on the back of macroeconomic uncertainty, high-quality corporate bonds continue to benefit from strong technical tailwinds. The impact of higher interest rates is likely to be more pronounced in leveraged issuers. High Yields are seeing larger incremental costs on funding and refinancing, particularly in the lowest-rated segments. As a result, the risk of rating downgrades is increasing, namely in the lower single-B rated bonds.
In summary, we keep a preference for IG corporates. With yields at the higher end of the long-term range, investors have a sizeable cushion in expected carry returns against further rates volatility. The risk of losses from potentially widening credit premia can be mitigated through a high-quality bias in a well-diversified portfolio.