After two months of heavy exuberance in November and December last year, January 2024 was marked by moderation. Returns across fixed-income asset classes were mostly muted as investors dialled back the prospect of rate cuts in Q1 while supply was huge at the beginning of the year. Rate markets delivered mostly negative returns, with only Australia managing positive performance, while the UK and the core eurozone were in negative territory from the start of the year. Core rates such as Germany and France saw a sharp increase in yields, while peripherals were more mixed, with Greece and Ireland outperforming Italy and Spain. Despite strong supply, Spread markets were also fairly erratic as Euro high yield (+0.6%) outperformed Euro investment grade (-0.6%). EM debt experienced subdued performance, with the hard currency segment (-1% in USD) suffering from an increase in US rates and the local currency markets (-2.3%) impacted by the strength of the US dollar, as US continued to surprise on the upside.
Our base case macro-economic scenario remains a soft landing, with our GDP growth forecast for the US increasing substantially (from 1.9% to 2.4%), while inflation expectations have only seen a small up-tick (2.6% to 2.7%). There was little change to the European economic scenario, with disinflation continuing and growth still weak.
Overall, our views on key markets for the month ahead remain broadly unchanged and we remain neutral in terms of both duration positioning as well as credit positioning. However, we do feel that there will be interesting opportunities over the coming months to increase the duration positions in the US and EU.
US Rates: tactically neutral as we believe that entry points will arise soon
Our neutral view on US rates has been maintained. The growth/business cycle score for the US has been upgraded, with a higher probability of repair and with an improved GDP growth picture. The inflation cycle remains unchanged and we expect disinflation to continue. Certain data prints from the United States do indicate that the economy remains resilient, with a very strong Non-farm payrolls number and ISM services. Jerome Powell has already indicated his willingness to cut rates, although the amplitude and timing remain up for debate. We feel that a first cut in May/June is the most probable scenario, with two to three further cuts over the rest of the year. Some negative signals also came from higher investor positioning. It is important to note that we do believe that rates will move lower in the months ahead and we stand ready to move to a more positive stance, while we are remaining tactically neutral in light of some of the positive data we have seen.
UK: neutral stance from a positive bias
Our Long position on UK rates has been reduced to a neutral stance. The Bank of England meeting led us to believe that there was a risk towards the hawkish side, as two committee members voted for a hike, and the disinflationary process is slightly behind in the UK. Given the greater prominence of disinflation in the EU and the more dovish stance of the ECB, the spread trade was not as effective as expected. With the Conservative government likely to have a voter-friendly budget in the run-up to the elections (likely in January 2025), there is a possibility of a small resurgence in inflation. Over the longer term, we do expect to have more entry points into the long gilt trade.
Eurozone rates: neutral as we await opportunities
Similar to the US, we remain neutral to the eurozone markets while awaiting some opportunities to establish a long duration position. On the inflation front there do not appear to be big changes as deceleration continues across different components. We are paying attention to events in the Red Sea (that have driven container shipping costs sharply upwards), but currently the impacts appear to be small in magnitude. In terms of monetary policy, it is worth noting that Christine Lagarde kept all her options open, while appearing more confident on the inflation numbers, rendering the stance more dovish. We believe that rate cuts are unlikely over the next three months and have our sights set on a potential June rate cut, though of course the ECB remains data-dependant. Markets do seem to be pricing six rate cuts this year, which could be considered excessive. In terms of investor positioning, we do see long positions as being fairly prominent, further prompting us to hold a neutral stance. Finally, in terms of supply, we are seeing an increased number compared to the beginning of last year, with Italy and Spain being particularly active, though overall supply dynamics have turned neutral for February.
We continue to hold a long-standing conviction favouring Austrian rates over French rates, which we see as being overvalued. We remain underweight on Belgium, where we see both rating risk and the risk of political uncertainty due to difficulties around government formation following elections later this year.
EMD: Turning positive on Corporates, maintaining a positive view on Local Rates
Performance has stabilised as the strength of USD has impacted EM FX, while the hard currency segment has been impacted by the uptick in US treasuries.
We have established a positive stance on EMD corporates, driven in part by improving technicals as we expect negative net financing with the expected cash flows outstripping supply. Net financing flows were favourable on the corporate compared to financials. Fundamentals are also improving as EM corporates have a lower level of debt vs developed market corporates, and the leverage continues to move lower. The interest-rate coverage ratio has also improved significantly. The asset class boasts a decent rating, with 60% investment grade issuers. Valuations remain fairly neutral, although we expect spreads to narrow.
For Local Rates, the outlook remains constructive as we expect growth to slow down, though in a relatively modest manner. Inflation, on the other hand, is expected to move substantially lower and central banks are likely to implement rate cuts, thereby supporting the positive stance on local currencies. Absolute yield levels are fairly elevated, though appear to be relatively tight vs US rates, and real rates remain positive for the main EMD LC markets. While EM FX are seeing some weakness, fundamentals do appear to be supportive, with current account balances improving. Foreign ownership is relatively low and outflows appear to be behind us, yet again providing a source of support.
FX: tactically Long JPY, NOK vs SEK and AUD vs NZD
After timely profit-taking in early January, we have yet again introduced our long JPY vs USD trade. Fundamentally, we still believe that the yen is undervalued and the expected rate hike in the coming months should support the currency. We hold on to our long NOK vs SEK and AUD vs NZD pair trade. Among Scandinavian countries, we see recent SEK outperformance as driven by the central bank’s currency hedging programme, which it is now set to wind down. The Riksbank has been selling substantial amounts of USD and EUR in an effort to maintain the value of its currency reserves, which had appreciated in SEK terms. Conversely, the Norwegian Central Bank, Norges Bank, has announced its intention to cut its purchases of foreign currency against NOK.
In the Antipodes, our long AUD position vs short NZD continues to be driven by conventional monetary policy rather than central bank interventions in currency markets for non-monetary reasons. Since the Reserve Bank of Australia was one of the most dovish developed market central banks, vs a very hawkish Reserve Bank of New Zealand, the latter is now substantially further along in its monetary cycle, with two cuts priced by August – compared to two cuts for the whole year in Australia.
Prudent on credit in light of technical factors
We are tactically maintaining our neutral view on EUR credit (both IG and HY). We do not have major concerns on fundamentals (as EBITDA margins, leverage ratios and cash positions generally remain strong), but valuations are not cheap, and technicals are not favourable for the asset class. On the one hand, we are neutral on valuations as it remains (at best) at fair-value, and spreads continue to be tight even on the financial sector, especially considering the recent decline in spreads that we have seen very recently. On the other hand, technicals are less supportive. Research indicates that investor positioning on Euro Investment Grade credit remains very long (the beta remains at very high levels (90th percentile), while it is neutral for high yield). Supply should also be elevated during the second half of the month, after the end of the Q4 earning season. Whilst appetite remains strong and primary deals continue to be oversubscribed, all else equal and without compensating tailwinds, we prefer to move to a more prudent position.