Oops, there goes gravity
Interest rate cut expectations were emboldened by the outcome of the Federal Reserve’s (Fed) latest policy meeting. Bonds and equities have rallied, and the final quarter of 2023 has been stellar in terms of investment performance. I am worried that recent weeks have stolen some of the returns expected to come in 2024. Cash has not looked that great recently and if cash rates are retreating, there may be more investment to come in global bond and equity markets. Yields, volatility, and risk premiums are all down. It is a bull market for now. The unknown factor is whether markets need to snap back to reality?
Bond yields have tumbled recently. This week the market enjoyed a shot in the arm, as the Fed appeared to begin its pivot towards easier monetary policy. The Fed kept rates unchanged at its 13 December meeting but accompanying forecasts show a median expectation amongst officials that the Fed Funds Rate will fall from 5.50% to 4.6% next year. This is a 50-basis point (bps) reduction in the median forecast compared to those published following the 20 September Fed meeting. Just as important were the Fed Chair Jerome Powell’s comments at the press conference. He certainly made little effort to push back on market expectations of interest rate cuts in 2024. He suggested the Fed was at the peak of the cycle and that it would continue to monitor the effect on the economy of the accumulated monetary tightening so far. There was even an acknowledgement it wanted to avoid keeping policy too restrictive, for too long. It was dovish and markets loved it.
No push-back from the Fed
The narrative has changed from “high for long” to “high for not quite as long.” The market is pricing in the first cut coming in March 2024 with the Fed Funds falling to almost 3.75% by the end of the year. That is an easing of 175bps. If market expectations are anywhere near correct, the Fed would have been at the peak for eight or nine months. That is a reasonable period by historical standards but short of the 15 months at the peak in 2006-2007 which triggered the “Table Mountain” analogies earlier this year. It also means the chances of a soft-landing for the US economy – with inflation returning to target and the economy avoiding recession – are much stronger. Financial conditions are easing. Some worry this will spark a resurgence of inflation but it is just as likely to stimulate growth and deliver something above the 1.1% real GDP growth rate forecast contained in our 2024 outlook.
A lot done
The Fed is confident inflation will continue to ease and referred to softening growth data and some relaxation of labour market tensions. From now on, any data weakness will be seized upon by markets, further emboldening rate cut expectations. Some push-back in terms of rate cut timings is likely to be forthcoming from Fed officials, but the cat is out of the bag in terms of the end of rate hikes and the next phase of the cycle being characterised by monetary easing. Market momentum will be hard to shift. Which makes 2024 are bit more challenging from an investment point of view. The bond market has already done a lot of what I expected for next year.
Since the 10-year Treasury yield peaked on 23 October, the total return from the US Treasury index has been close to 6%. For UK gilts it has been 7.4% and for European government bonds, also 6%. Global investment grade credit returns have been 7%. These are the kind of returns we would have expected for 2024. It is encouraging that the market has been buying fixed income – 5% was clearly a “cheap” mark in the sand. However, at a sub 4% yield, the return expectations need to be scaled back.
Easing, how much?
The market is likely to have moved too far in terms of expectations of monetary easing – or at least has factored in most of the easing if the US economy is going to achieve a soft landing. Powell did mention he was watching real interest rates and wanted to avoid them being too high. A naive interpretation of current real short rates puts them around 2.0% to 2.5%. This is above the expected growth rate of the economy in 2024 - and above the average of the last 40 years. However, averages can be misleading. Prior to the global financial crisis, real short rates averaged between 2% and 3%. When the economy went into recession, they tended to fall to zero. Since 2009, they have been below zero much of the time but that is not likely to be the norm anymore. Assume the Fed wants to see the inflation adjusted Fed Funds Rate fall to between 1% and 1.5%. With inflation set to average around 2.5% next year, this indicates a Fed Funds Rate of 3.5% to 4.0%. The market is already close to pricing that in for the end of 2024. A recession could see the rate fall to 2.0% but that is not the base case scenario now.
As monetary policy eases, yields curves tend to steepen. A 3.5% to 4.0% Fed Funds Rate with a positively sloped yield curve does not provide much further room for long-term yields to decline. A prudent expectation is for the 10-year yield to settle into a 3.5% to 4.0% range. Other bond markets will take their cue from local central banks, but it is a similar story. The market expects the European Central Bank to cut the deposit rate to 2.5% - an easing of 150bps over the course of 2024. Market expectations for the Bank of England had lagged, but now the base rate is expected to fall between 80bps and 100bps, despite the market’s hawkish message delivered this week. Markets are pricing official rates to fall to what many would say were neutral, equilibrium long-term levels.
Change of focus for 2024
In terms of expectations for fixed income returns now, the focus must be on carry (income). If yields are approaching a neutral range in terms of valuation, then capital gains from bond portfolios will he harder to come by. I wrote last week about how income returns from credit portfolios had picked up, this will be even more important in 2024. Not everyone has been in the bond trade – there were plenty of investors wary that yields would go even higher than October’s levels – and this may encourage some additional buying in the short-term. However, the challenge for the next year must be allocating capital based on more stability in rates markets with long-term yields probably trading in a range around the mid-point of where they have traded in the last two years at between 3.5% and 4.0% for US Treasuries, 1.5% to 2.0% for Bunds, and 3.25% to 3.75% for gilts. The additional challenge is to adapt when things change – be more bearish on bonds if the inflation battle must be fought again, and more bullish if it turns out that – as one of my equity colleagues proposed – the Fed knows something (bad) which we do not.
Talking of equities, the Fed pivot is good news. Lower bond yields help valuations (price/valuation of earnings and relative to bonds) while the greater confidence in a soft-landing means a better chance of meeting earnings expectations. Our 2024 macro-outlook expects a soft-landing and companies will still face the headwind of slower nominal growth impacting revenues. But if the Fed eases, the outlook improves. Meanwhile, the debt refinancing picture looks better. The yield on the five-to-seven-year US corporate bond index has fallen 120bps from the October peak and is now back at the same level it was at the end of 2022. True, financing costs remain higher than they have been for over a decade, but they are off their worst levels and could move lower still. I stick with the positive view on corporate credit – and high yield for that matter. And for equities, the interest rate environment now leads to a less negative view. One of my 2023 narratives has been that the 60:40 portfolio is back and for 2024, a balanced bond and equity approach should be attractive for investors.
Happy holidays and good investing in 2024
This is my last note until January. I am off for a well-earned rest over the holidays with the family. I will not be sad to say goodbye to 2023. Markets have been tough; the industry has been tough, and football has been awful. I am not sure football will be any better in 2024. On the business side, UK asset managers need to get their Sustainable Disclosure Requirements (SDR) compliant investment offerings in order – something that gives the industry another opportunity to encourage capital to flow to sustainable investments. A better economy and more stable yields could be something that encourages more investment into green technologies and help – as suggested at COP28 – the world to reduce its reliance on fossil fuels. Politics will also have a lot to say on that front. Now it is hard to see a wave of carbon-transition advocates winning elections around the world. However, there is a steady shift in the flow of capital, and green technology is becoming cheaper and more scalable. The world should remain on its carbon transition path, and it will again be a major political and investment theme in 2024.
(Performance data/data sources: Refinitiv Datastream, Bloomberg, as of 14 December 2023). Past performance should not be seen as a guide to future returns.