The path of inflation has preoccupied many investors over the past 18 months as markets normalise after a long period of quantitative easing (QE) and near zero interest rates, according to Insight’s Andy Burgess.
Now, after a steady series of interest rate hikes aimed at curbing rising inflationary pressures, he believes that inflation has peaked and appears to be on a downward trend towards central bank policy targets. But this does not, he adds, mean heightened market volatility is over.
According to Burgess, there remain significant potential divergent forces ahead to create an attractive environment for active managers to exploit.
Central bank action
He points out that inflation is falling in response not only to base effects but also the restrictive nature of monetary policy. However this, he adds, has been achieved so far without a sharp recession.
“Markets have, over the last few months, bought into the ‘immaculate disinflation’ narrative that policy rates can now be cut, with up to six 25 basis points of rate cuts priced into the US and Europe at the end of 2023,” he says.
Burgess believes that although policy rates are likely to fall in 2024, the market expectations as to the pace and extent of further cuts may be being overestimated. He adds that central bank measures will likely disappoint some analysts and be less aggressive than widely predicted across major markets such as the US and Europe.
“Policymakers have been wrestling with the question as to whether they have they done enough to put the inflation ‘genie’ back into the bottle,” he adds.
“We believe there is a strong base case for lower inflation and no recession in 2024. From a bond market perspective our view is that while yield volatility is here to stay, and while we do expect to see some rate cuts throughout the year, wider market rate cut expectations may be overdone.”
Either way, Burgess believes diverging interest rates and inflation levels across major markets, together with intermittent patches of volatility, are creating wider differentiation between sovereign bond markets. This climate, he adds, is exposing potentially attractive fixed income investment opportunities across a range of geographies, asset classes and sectors.
“Volatility is not just impacting the direction of global bond yields across the world. More importantly it is reintroducing economic divergence between countries and bond markets. We are increasingly seeing new pockets of opportunity emerging across major markets,” he says.
“Japan is perhaps the most significant outlier and the only major developed market where we expect to see policy rates go up this year. But several countries are also moving through different stages of the economic cycle with different sensitivities to interest rate hikes.”
Market turbulence
Burgess believes bond yield volatility and wider market turbulence are here to stay as markets normalise and position themselves to shield from potential threats ahead.
“A number of factors point to ongoing market uncertainty,” he says. “The economic impact of our move to a low carbon economy could potentially prove inflationary. The evolving nature of technology and its impact on companies also cannot be ignored. Importantly, we do not yet know what artificial intelligence (AI) may do to company productivity in coming years or how it will influence our ability to grow as a global economy and drive inflation up or down.”
In this increasingly uncertain world, Burgess adds, geopolitical risk and a raft of upcoming elections pose further potential investment threats.
“Both the upcoming US election and a looming UK election hold scope for further market upsets and will play out against a wider climate of geopolitical uncertainty across the globe,” he adds.
Despite the potential threats facing investors, Burgess believes shifting markets could present some fertile territory for active fixed income managers able to spot the emerging opportunities they present.
Commenting on credit market opportunities, he says: “Although from a top-down perspective, we believe investment grade is close to fair value, when you look closer, there are a lot of pockets of value between credit markets (such as Euro versus US dollar markets) and between segments of the credit market. Dispersion between individual bonds is also larger than it was five years ago, reinforcing our belief that a rigorous approach from both top-down and bottom-up can add value for investors.”
High yield opportunity?
Beyond more mainstream sovereign and corporate bond investment Burgess sees significant potential in the short-dated high yield and asset backed security (ABS) markets.
“Current yield levels suggest corporate bonds can be an attractive asset class versus equities and some other investments, particularly in Europe. In our view the high yield and ABS market - which we believe currently offers some extremely attractive levels of spread and opportunity - should also be strong enough to weather higher interest rates and could thrive in current market conditions,” he adds.
From a sector perspective Burgess believes the banking sector is particularly attractive given the longer-term trend has been for banks to make themselves more resilient. Larger banks tend to be safer and much better capitalised today than they were in the past, he adds.
“The amount of capital theses banks now have to absorb potential losses is considerable versus historical averages and we believe debt may be somewhat undervalued in this sector. The property sector is also one that has outperformed recently, given the bottoming out of some property market valuations and with the expected decline in short-term interest rates providing some support.”
“In our view, areas of the market are still vulnerable, however, with the outlook for the smaller US regional banks still uncertain. We believe areas of the credit market that are more cyclical in nature may also come under pressure as growth slows in 2024,” he concludes.
