Fixed Income Forward: December 2023

There is another side to the year-end bond rally

November’s rally in bonds has spilled well into December after major central banks again kept rates on hold. Importantly, the US Federal Reserve lent credence to the idea of rate cuts in 2024, whereas the European Central Bank and Bank of England didn’t go that far. But we think there is more to this story than simply trying to project how many cuts, and how early. The year-end bond rally has extended the outperformance of credit over rates, with one implying a somewhat different view on current financial conditions than the other.

Corporate credit and emerging market debt seem to side more with the view that multiple rate cuts will pre-empt a painful recession. The argument goes that central banks may have unwittingly over-restricted financial conditions given the speed at which annual core inflation has fallen in the US (to 3.5%) and the euro area (to 3.6%).1 The annualised rate of threemonth core inflation is already running below 2.5% for both economies. Higher prices are now limited mostly to services.¹ Those prices should soon come down too, along with a pullback in consumer spending1 and corporate profits – prompting central banks to cut rates before higher borrowing costs really start to hurt issuers’ ability to service and refinance their debt.

Core rates are sending a more reactive message. German and US 10-year yields have fallen by around 100bp after hitting 3% and 5% respectively in late October.² By one measure, US financial conditions are now back down to levels seen before rate hikes began in March 2022.³ But yield curves are still inverted as more policy-sensitive twoyear yields have come down by less. This suggests bond investors are yet to be totally convinced that conditions are restrictive enough for core inflation to settle lower – especially if the last leg down turns out to be lengthier and bumpier due to better-than-expected economic activity.

Sources: Bloomberg, ICE BofA and JP Morgan indices; Allianz Global Investors; data as at 30 November 2023. Index returns in USD-hedged except for Euro indices (in EUR). Asian and emerging-market indices represent USD denominated bonds. Yield-to-worst adjusts down the yield-to-maturity for corporate bonds which can be “called away” (redeemed optionally at predetermined times before their maturity date). Effective duration also takes into account the effect of these “call options”. The information above is provided for illustrative purposes only, it should not be considered a recommendation to purchase or sell any particular security or strategy or as investment advice. Past performance, or any prediction, projection or forecast, is not indicative of future performance.

We stick by our view that now is the time to position bond portfolios to profit from global divergence in after-inflation or real yields (see Chart of the Month). Core inflation has come down rather quickly, since in the post-pandemic period it was driven largely by supply-chain disruptions accompanied by a strong comeback in demand. Looking ahead, however, the risk that higher-for-longer inflation and policy rates will reignite a rise in yields and spreads very much depends on which economy we’re talking about.

Assessing that risk requires a closer look at how core inflation interacts with the job market. Labour cost growth has had a smaller impact on core inflation than price markups.⁴ And excess savings are to blame, rather than growth in real wages, for boosting consumer spending.¹ From this perspective, labour markets are less “tight” than they appear to be. US unemployment has been below 4% for 21 straight months and is lower than in the euro area (6.5%).⁵ Yet, we see greater reinflationary risks in Europe coming from collective wage bargaining possibly pushing up wage growth. Higher wages are not necessarily inflationary if they coincide with higher productivity, which helps stabilise the factor that impacts inflation most: labour costs per unit of production. But labour productivity in the euro area is already weak or falling.⁶

Weigh up emerging markets

For higher positive real yields that look well balanced relative to inflationary risks, emerging market debt stands out. At the end of November, emerging market local currency sovereign debt was the second-best performing fixed income asset class year-to-date behind US high yield, delivering 9.2% in (unhedged) USD terms.⁷ A weaker USD accounted for about 40% of that total return. In general, emerging market central banks have stayed ahead of the curve in raising rates and arresting inflation. In addition, labour costs in emerging markets are unlikely to refuel inflation as they account for only a third or less of total production costs.⁸

1. Challenged profit margins
The interaction of core inflation and the job market can also be paramount for corporate credit selection. In an economic downturn, consumer spending and labour productivity typically take a turn for the worse. Sectors and companies that prove more agile in recalibrating their workforce and operations should be able to best defend profit margins.

2. Credit spread sustainability
While labour markets may not be as tight from the perspective of labour cost growth, corporate credit spreads look very tight by several measures and across regions, sectors and rating bands. We’ll be looking closely at how fundamentally sustainable these tight spread levels are, especially in the event of a sharp pullback in rate cut expectations for 2024.

3. China at the crossroads
The market impact of Moody’s changing its outlook to negative for China’s sovereign rating has been relatively muted. Meanwhile, China’s consumer price index fell 0.5% year-on-year in November.⁹ Watch out for more accommodative measures, but with a reactive (not aggressive) stance seeking to backstop downward pressures on growth while allowing painful structural reforms (eg, property sector) to run their course.