Against a backdrop of volatile trading, August saw the return of a correlation between risk assets and rates, with investors in most asset classes ending the month flat or with moderate losses. Investors in US HY and EUR govies and IG corporates fared best, while EMD suffered the most, driven by worries about weak activity data in China. Within EUR government bonds, core countries outperformed non-core countries, with Austria leading the way.
The UK: a decoupling from other developed economies, a buy opportunity for gilts
In the UK, forward-looking indicators point to a further deterioration in the economy. While certain trends such as a decrease in PMIs hold globally, they have been more pronounced in the UK. Unlike other G10 economies, unemployment has also risen markedly. We expect this to continue to increase, and unemployment is very much a lagging indicator – leading indicators such as the ratio of vacancies to unemployed have worsened. While a degree of softening in labour markets has also been observed elsewhere, for the time being in the US and eurozone, the impact on actual unemployment has been much lower. Compared to most developed market peers, the structure of the housing market – with rates that typically reset within 3-5 years – also renders the country far more vulnerable to rate hikes. This is beginning to have an impact on property prices. Between labour markets and housing, we are therefore seeing clear disinflationary forces at work. After repeated inflation surprises to the upside, indicators are therefore finally beginning to indicate a turnaround.
Currently, markets are pricing a terminal rate of 5.75%. We think this is possible, though it is at the higher end of what see as a range of likely outcomes. Our disagreement is more fundamentally with the extent and speed of rate cuts thereafter: the market currently is still pricing 5% for the end of 2024, a level that we view as far too restrictive.
Globally, we see most countries’ neutral rates as being higher than they were pre-Covid, driven by secular forces such as the greening of the economy and reshoring. However, we believe that due to structural changes as a result of Brexit, the UK economy will not be able to support rates at these levels in the longer term.
We increase our conviction in UK rates, as we believe that the market will come around to the view that in this respect, the UK constitutes something of an outlier among developed countries.
In Norway, we are also moving to a positive position on rates. In many ways, our rationale is similar to that for the UK: excessively hawkish market expectations on the central bank and a very direct feed-through of higher interest rates to the real economy via variable-rate mortgages.
Softening leading indicators confirm our long views on US and EUR duration
Our fundamental view on US duration remains positive. Survey data has deteriorated over the last few months. Some signs of weakness are apparent in labour markets. While robust overall, a negative print in non-farm payrolls in the coming months certainly seems possible. As inflation comes down, real rates are moving up into increasingly restrictive territory – a sign that we are approaching the end of the hiking cycle.
Inflation also continues to come down, although there appears to be some uncertainty in the market as to the terminal level, and when that will be reached. The term structure of inflation breakevens is flat, at around 2.5%, and has recently decoupled from movements in energy markets. This appears to suggest that assumptions have converged on a “default” level of the 2% target, plus a risk premium.
In the eurozone, we see both inflation and PMI coming downwards. Recent comments by ECB council member Isabel Schnabel had a distinctly dovish inflection, leading the market to price the “no hike” scenario. If this holds true, we think it is likely that no hikes will follow: signs of a cooling economy will probably consolidate, making any hike thereafter appear excessive and difficult to justify.
Emerging markets: select opportunities in local currencies
We are upgrading our view on Chinese rates to neutral, based on the continued disappointing weakness of the economy and problems in the property market. That said, we clearly still do not see Chinese rates as a buy opportunity. Indeed, most EM LC rates do not, in our view, offer sufficiently attractive spreads to US Treasuries, although we like select markets that offer high real yields and good carry: Mexico, Indonesia and India.
Credit: lower growth and inflation will put pressure on margins
At the beginning of this several-decade high inflationary period, the main question many credit investors asked was: will firms be able to pass on costs to consumers? We have now seen that not only were the vast majority able to do so, but that in many cases price increases have overcompensated for cost increases. Margin expansion has, arguably, itself been one of the primary drivers of inflation.
In an economic environment where consumer confidence is falling and firms’ margins are facing increasing scrutiny, we believe that we are closer to an environment where we could see spreads widen. Nonetheless, carry remains attractive, and we do not anticipate major difficulties for issuers to refinance in the near and medium-term future.
This compels us to return to a neutral view overall on European IG credit, whilst at the same time reinforcing our relative preference for financial over non-financial issuers.
In US credit, fundamentally our conviction remains the same: although the segment does not give us reason to worry, spreads are simply not attractive enough, especially for EUR-based investors.