Risk of a hangover from the 2023 year-end party bonanza

We see bumps in the road ahead…

Fixed income yields and spreads have traded somewhat softer in the first week of the new year, following a bumper end to 2023. Over the months of November and December, the Global Aggregate Bond Index posted a return of almost 10%, making this the best two month gain since 1990. This performance had come on the back of declining yields, as inflation data slowed and central bank messaging signalling prospective rate cuts ahead, during 2024.

These developments had seen a rush from investors seeking to deploy cash into the market, in anticipation of an easing cycle to come. However, this led to valuations becoming stretched into the end of the year, meaning that it always looked a challenge for the new year to pick up where the old one had left off.

From our own perspective, when assessing market projections for rate cuts as early as March this year, we see plenty of room for disappointment from the Fed, ECB and Bank of England. In the US, the economy continues to grow at a healthy pace and with the housing market activity being stimulated by the recent decline in mortgage rates, we don’t think that the FOMC will be in a hurry to cut rates.

Meanwhile, we won’t be surprised if inflation data during Q1 proves more durable than many have been expecting. Market participants have been quick to dismiss inflation risks, as headline CPI has declined, yet core inflation remains well above levels compatible with central bank targets.

Moreover, with the labour market at full employment, the stock market close to record highs and financial conditions materially easier than levels seen earlier in Q4, it seems an unusual backdrop for the Fed to commence monetary easing, even if rates are at levels which are deemed to be restrictive.

Looking further ahead, we do think that the US economy will slow into the second half of the year, as past policy tightening continues to have an effect.  However, we think this is consistent with two rate cuts by the Fed in the second half of 2024, which is materially less than the 125bps of easing, which is currently discounted.

From this point of view, we continue to be inclined to adopt a cautious stance on duration as we commence 2024. That said, we think there is probably more scope for UK yields to rise than their US counterparts. Although the UK economy looks materially weaker than is the case across the Atlantic, inflation continues to remain materially higher, and we suspect UK core CPI will remain around 5% in the months ahead.

Inflation and wage expectations continue to be elevated in the UK and with the government having already declared its success at bringing inflation under control by getting it down to 5%, we are doubtful that we will see it trend much lower in the foreseeable future.

Meanwhile, comments from Westminster lead us to believe that there may be a material fiscal easing in March, with the Tories hoping to gamble that they will be rewarded with this at upcoming polls later this year, whilst acknowledging that in a likely defeat by Labour, then fiscal easing today will only put an incoming Administration in a more difficult position.

Indeed, 2024 is quite a big year in terms of politics and elections globally. Voters will also be going to the polls in the US, Mexico, India, South Africa, Russia and Turkey, amongst others. In fact, elections will occur in seven of the world’s ten most populous countries in the year ahead, with 40% of the planet’s population eligible to vote across 50 national contests.

Unsurprisingly, much of the focus of attention will be on events in Washington, though we would note that at this juncture, it would now come as a surprise if Trump does not end up back in the White House, given his double-digit lead over Biden. This is notwithstanding moves to remove Trump from the ballots in Colorado and Maine, something which is widely expected that the Supreme Court will intervene to overturn.

Nevertheless, prospects for a fractious climate in US politics is likely to make an extended US government shutdown a more likely outcome in the months ahead. Indeed, this is something which could come to the fore later this month as last year’s stop-gap measures run their course, though it is questionable how much of an economic impact this is likely to have.

Meanwhile the political calendar is somewhat quieter in the Eurozone, though we would continue to highlight building political trends across the continent, which are a source of growing concern in the corridors of Brussels and beyond.

Over the past year, it has been interesting to note the continued rise of right-wing, pro-national parties in a number of countries. The stock of Georgia Meloni is riding high in Italy, whilst in the Netherlands there was shock in the establishment in the gains made by Gert Wilders’ party on an anti-immigration, anti-green agenda.

Meanwhile, German voters have been moving toward AFD and in France, Marine Le Pen would be in an interesting position to make a strong run at the French presidency, were there to have been upcoming elections in the next 12 months. Although Eurozone stability is not under any immediate threat, political volatility cannot be ruled out, particularly were the current economic downturn across the continent to run into a more protracted recession, with materially higher unemployment in the quarters to come.

Eurozone yields have been little changed at the start of January. December inflation data ticked higher, as expected, and we continue to believe that the market is premature in pricing rate cuts from the ECB as early as March.

With core CPI still seen around 3.4%, this remains well above target and although the Eurozone economy has been struggling over the past few months, recent indicators in areas such as house prices suggest some stabilisation. Labour market data also continue to hold up relatively well and from this point of view, we do not sense any urgency to begin a rate-cutting discussion from Lagarde or her peers.

Elsewhere, the dynamics in Japan stand out, in contrast to other developed markets. The Japanese economic outlook remains relatively upbeat, core inflation remains close to 4% and there is building evidence of an upturn in wage growth. Recent BoJ comments suggest that policy normalisation is likely to proceed over the next several months and we continue to think that there is scope for an end to the Negative Interest Rate Policy (NIRP), which will be forthcoming at the BoJ policy meeting at the end of January.

The recent Noto earthquake has created some uncertainty with respect to timing and it is possible that the BoJ will decide to take some time to assess its impact. However, we would suggest that the likely economic consequence will be additional fiscal spending, as infrastructure is rebuilt, and that this will end up showing as a net positive in GDP data.

From this point of view, we remain confident on policy normalisation in Japan in 2024 and look for the government to declare attainment of ‘inflation at 2% on a sustainable basis’ by the spring.

Thereafter, we think that interest rates will end the year at 0.5-0.75%, with Japanese rates moving higher, just as they turn lower in the US and Eurozone, given the very different starting points these economies will be coming from. This being the case, we expect the recent rally in JGB yields to be reversed in the coming weeks.

We also think that the yen will outperform other major currencies in the year ahead, though in FX the negative carry associated with being long the Japanese yen makes this quite a difficult position to sit on with large conviction, unlike Japanese rates.

Credit spreads narrowed materially in both corporates and sovereigns into the end of 2023. However, a resumption of supply at a concession to secondary market issues has seen spreads widen at the start of January. Having reduced exposure into the year end in anticipation of a resumption of issuance, we have been eager to participate selectively in new issues, though it remains important to stay focussed on where fair value sits.

Indeed, over the past several days, many new issues have traded wider at re-offer, notwithstanding strong book building. With plenty more new issues set to come over the next few weeks, there is a sense that investors can be selective where they add, given how far spreads have rallied of late. Consequently, where new issues have been priced wide relative to existing deals, so this has led to something of a re-pricing wider, as deals have been announced.

Looking forward

There seems plenty of uncertainty ahead. Saying that, it has been interesting to note that many banks have brought forward their projections for monetary easing, essentially following recent price action.

However, we are sceptical that there will be a smooth and simple trajectory. As we have noted, even the recent easing of financial conditions, associated with hopes for monetary easing, are enough to help lift economic data and thus negate the need to deliver rate cuts on the timeline markets are hoping for. Moreover, with a soft landing seemingly fully priced in some assets, we think there is a risk to markets becoming disappointed, if data do not conform conveniently to this narrative.

Given markets are already discounting around 125bps of rate cuts during the coming year, there is essentially a lot of good news for government bonds already embedded in prices. With yield curves inverted, this leads us to doubt that fixed income indices will deliver returns much better than cash in the coming 12 months.

That said, we believe that the price action witnessed in 2023, which was punctuated by periods of higher yields then lower yields, could easily play out again in the coming months. From this point of view, we see opportunities in taking both directional risk positions as well as relative value positions across markets.

We can see bumps in the road ahead and arguably a VIX below 14 does not really price for this. Being over-confident for now may end up looking as wise as trusting the recent Tik-Tok trend of eating 12 grapes on the stroke of midnight to guarantee success in the year ahead. Experience suggests that after a party, there is normally a bit of a hangover to follow….