Quarterly fixed income outlook: October 2024 | Insight Investment

Politics will increasingly take centre stage, with the final weeks of what appears to be an uncertain US presidential election being the highlight, but also a snap general election in Japan expected for later in October. We see a backdrop in which economic growth in most developed economies moderates to sub-trend levels, while inflation gradually eases back to the respective target levels set for central banks. Having begun, monetary policy easing is expected to continue through the final quarter and into 2025. While recession may be a risk, it is not our central case. Central banks have enough scope to cut rates rapidly if growth rates appear to stagnate. Equally they will avoid easing too quickly in case inflation starts rising more meaningfully again.

The gradual decline in US leading indicators is signalling a general slowdown in the world’s largest economy, in our view, falling below trend to around 2.5% in 2024 and 1.6% in 2025, as both consumer spending and business investment continue to normalise. Even slower job creation than has already been seen could represent increased downside risk. On inflation, we believe that though the headline rate may continue to oscillate, it should moderate down toward the Federal Reserve’s 2% target rate, though it may take some time to do so. We expect the Fed to cut rates further, with a terminal rate of around 3%, though potentially not until 2026. We expect Treasury yields at shorter maturities to reflect the reduction in official rates but yields at the long end could rise slightly from prevailing levels.

Europe’s recovery continues to be led by the periphery although the manufacturing sector has been under pressure for some time and remains very weak. While the European economy is not particularly resilient, real wage growth is expected to remain positive, which could support consumption. Overall growth in 2024 is likely to be well below the US; but in contrast to the US, we expect it to improve in 2025, though remain below trend, reaching about 1.3%. Headline inflation is expected to sustain its fall to the 2% target level, while the European Central Bank (ECB) is likely to cut rates further, taking the benchmark deposit rate to around 2.5% or even lower in a year’s time. Yields may decline at shorter maturities as the ECB cuts rates further, but at longer maturities they could rise slightly.

Having enjoyed a slightly stronger start to 2024, we see the next few quarters being similarly positive, though not materially so, leading to an eventual GDP growth rate of just above 1% in 2024 and close to 1.5% in 2025. Headline inflation is likely to trough at around current levels before accelerating modestly into year-end, as energy base effects become less favourable. However, wage-growth stickiness could continue. Additionally, to raise revenue, it is likely that fuel duties will go up. As a consequence, we forecast inflation to remain above target throughout 2025. Markets will have an eye on the chancellor’s first budget at the end of October, following clear warnings that tougher times are ahead. We expect the Bank of England to cut rates further in coming months and to take them to around 4% in the next year. Gilt yields are likely to remain close to current levels, or even rise slightly at longer maturities.

In China, the recent disappointing economic data and deepening property-sector malaise prompted new stimulus measures from the authorities, mainly focused at stimulating credit demand. The external sector has remained resilient but appears to be softening in the second half of the year. Domestic demand continues to run below trend and weakening household and business confidence remain key issues. We believe policymakers would like to avoid too much re-leveraging but are attempting to make things easier for lending and borrowing. We expect the economy to undershoot this year’s 5% growth target a little with a deceleration to around 3.6% in 2025. Inflation is edging up toward our expected 1% level for this year, and we think it is likely to rise slightly to around 1.5% in 2025. Elsewhere in emerging markets, many countries continue to experience elevated inflation, making substantial interest rate cuts difficult to implement. Central banks will have to navigate the fine line between preventing a resurgence in inflation and driving economies into a potentially damaging downward spiral.

Credit markets continue to be caught between the dynamic of attractive yields that are back at levels comparable to the long-term returns associated with equity markets, and spreads that have tightened back to long-term averages. With the easing cycle underway, the US economy is expected to avoid recession, though it remains a risk. We feel markets have priced in too low a terminal rate for Fed funds, and this may result in modest upward pressure on longer-dated yields as data continues to prove resilient. Credit spreads could provide some degree of protection in such an environment. European credit markets continue to look more attractive, reflecting a softer economic backdrop. The upcoming US presidential election may lead to increased volatility, but we would see any short-term volatility as providing potential opportunities. Corporate issuance may increase in 2025, as companies look to refinance deals brought to market during the pandemic, and this could present attractive new-issue premiums opportunities and higher coupons to lock in.

Global high yield markets continue to exhibit a strong technical position, with the absolute level of yields and coupon reinvestment supporting robust demand, while supply is dominated by companies refinancing debt. With the easing cycle having begun, we expect this situation to persist, as investors look to lock in yields while they remain available. Returns are likely to be dominated by income, and there is the potential to enhance returns by careful security selection and the effective capture of call premiums. Defaults are running at lower levels than anticipated (at less than 3% in 2023 and so far in 2024) and we see no material signs of stress in the wider market, with declining interest rates now acting to underpin future economic activity. We see many companies continuing to address 2025 and 2026 maturities and extending their capital structure, which may provide opportunities to invest in higher-coupon issues.

Valuations are stretched in historical terms, particularly in the investment grade space, while high yield markets appear less so. Tactically we believe there remains some positive impulse, but it is not strong enough to overcome our caution in the IG markets. Among distressed names, we favour Ghana, Ukraine, El Salvador and Argentine. We are more positive and are happy to remain overweight in local currency bonds, notably in Colombia, Brazil and Peru. We see value in EM currencies too. The recent surge in economic stimulus in China will be welcomed by the market, but the fact that the authorities have felt the need to move in such a robust fashion does serve to highlight the scale of the issues the Chinese markets face. We retain a cautious stance on China corporates, where the high yield sector remains at distressed levels. 

This year has been characterised by solid, income-driven returns and, although the easing cycle has started, we see little reason for that to change in the near term, with central banks expected to ease relatively gradually. With spreads still attractive relative to similarly rated corporate credits we expect demand to remain high. We continue to senior issues with robust transaction structures that divert cashflow in the event of underperformance, and strong underwriting and servicing policies, all of which should insulate investors if the economy weakens. We have reduced our mortgage-backed securities (MBS) positioning to neutral as index spreads and current coupon nominals have been strong this year and reflect long-term fair value. We see limited room for MBS spreads to tighten but believe cross-market relative-value opportunities remain. We expect supply/demand dynamics in 2025 to remain similar: strong money-manager demand from inflows will probably need to continue to absorb increased net supply, but the main headwind is potential spikes in yield volatility, caused by such things as Middle East geopolitics, the US elections, and changing perceptions of growth and interest rates.

With the Fed starting the easing cycle, investors are returning to muni bond markets, and we are observing demand returning to the asset class. Oversubscriptions on new issues are ranging from between five to 10 times proposed issuance, depending on issuer and yield. We would expect issuance to dip significantly in Q4, with buyers having to turn to secondary markets to find liquidity. From a sector perspective we maintain a bias toward essential service revenue bonds (water/sewer, electric utilities) that we believe offer attractive yields and with solid credit fundamentals. This compares to state and local general obligation issues which tend to trade at tighter spreads and where revenues are more vulnerable to a slowdown in growth. There remain opportunities in sectors such as airports and toll roads. Idiosyncratic buying opportunities across all sectors and qualities mean there remains ample potential to add value via stock selection. Given the shape of the yield curve we believe maturities beyond 10-years may offer a favourable income and return profile.

While the USD may still be regarded as a high-carry currency, it remains overvalued in our view, and the market has priced in number of Fed rate cuts. At the same time, the US is at the centre of a negative data shift, and political uncertainty surrounding the upcoming election could further complicate the dollar's outlook. Tactically the USD looks set to gain some ground again, but any trends may not emerge until after the election. The parallel modest tightening theme in Japan can provide some support for the JPY. Similarly, China’s stimulus package could also undercut the dollar. The proximity of the US elections, combined with other building geopolitical tensions provide a breeding ground for uncertainties in currencies.