Return to the ‘old normal’

“2024 is a pivotal year. It is the year we can look back and say the period of zero interest rates, between 2008 and 2020, is now behind us. That was an abnormal period. We have returned to an ‘old normal’ world, forgotten for the past 12 years, and we think higher real interest rates are here to stay.

“This year could also be pivotal in terms of how central banks react to inflation. It is not a done deal that inflation will fall back to target, and it may take longer than markets think. The ‘everything rally’ seen in January and February of 2024 was a symptom of the market being too optimistic on the speed of interest rate cuts going forward.

“We think this pivotal moment is best represented by forward expected returns from fixed income. Higher interest rates have pushed bond yields up, meaning investors finally stand to receive an income from fixed income. That hasn’t been the case for the past 10-15 years. Plus, over the long term, fixed income returns tend to be dominated by the income component as opposed to the month-to-month or year-to-year capital variation.

BNY Mellon Investment Management chief economist Shamik Dhar

Newton¹ global income portfolio manager Jon Bell

A change in equity market leadership?

“We are at a pivotal moment for central banks. Should they cut interest rates? What does this mean for leadership in equity markets?

“We think in the current environment it is hard to believe central banks will aggressively cut interest rates. Two macro themes of big government and great power competition are at play, and both are inflationary. We see examples of these themes in action through central bank intervention, Covid lockdowns, and the influence on energy and food prices. Then there is the battle between liberal democracies and autocracies, the tech war, and conflicts in Ukraine and the Middle East.

“In our view, the might of these themes outweighs global disinflationary forces at play such as challenged demographics, high levels of debt and technological disruption. As such, we think the inflation genie has been released from its lamp.

When transitory became transitory

“For me, the biggest pivotal moment in the last 10 years was in late October 2021 when Federal Reserve chairman Jay Powell accepted that higher inflation was not ‘transitory’. From then short-term interest rates moved up significantly. This returned us to a more normal interest rate environment compared with the post global financial crisis (GFC) period.

“But in 2021, before Powell’s comments, companies were telling us they were raising prices because costs were moving higher. We could see then that inflation was not going to be transitory.

“I have a strong belief that you should throw away the playbook for what happened over the 10 years since the GFC. That is not what is likely to happen over the next 10, even 20, years.

Newton US equity income portfolio manager John Bailer

Walter Scott investment manager Alan Edington

Seeking quality in a changing world

“According to the artificial intelligence (AI ) chatbot ChatGPT, the pivotal issues in equity markets today are geopolitical shifts, technological advancements, rates, inflation, trade disruption, environmental issues and regulation.

“Inflation has been sticky and interest rates are likely to be higher for longer. There are signs the post-Covid consumption boom could slow, for example credit card delinquencies ticking higher.

“There is no doubt AI will drive earnings growth for lots of businesses over time. We see AI opportunities in the areas of healthcare, automation, and search and advertising among others.

“Elsewhere, geopolitical shifts and trade disruption dominate headlines. Semiconductors offer an interesting case study in this area. China and the US are trying to diverge, and certain countries are spending meaningfully to gain independence in the race around semiconductors.

Surprising economic resilience

“If you landed from space and someone told you inflation had been in double digits and interest rates had gone up almost 500 basis points in certain countries, you would expect economies to be in bad shape.

“But when we look at the global economy, we see an improving situation. We have been seeing reasonable levels of nominal growth and in this environment, companies can normally come up with enough cash to pay their coupon.

“I think central banks are thinking what in the world is going on – is growth speeding up or slowing down? The answer is a bit of both and that makes it an interesting picture for managing money.

“Companies have been smart – they’ve paid down debt and avoided issuing long-dated bonds, choosing to wait for the possibility of lower interest rates to reduce the coupon. Interestingly, we have not seen higher levels of defaults. Companies can go outside of banks to get money such as private credit and private equity markets. 

Insight Investment head of fixed income specialists April LaRusse

Insight Investment senior high yield portfolio manager Uli Gerhard

Low defaults in high yield

“With high yield it is important to be global in outlook because there are certain sectors we don’t want to buy. If you look at default statistics, we have seen very few defaults. We tend to have defaults when something extraordinary happens in the market: in 2020, we had Covid-19 which presented a major challenge. But most of the time, if investors pick the right companies, they should be OK.
 

“Economists will always tell you when bank lending tightens defaults go up. But that correlation doesn’t work anymore. Why? There is a very simple explanation: private credit. It is as big as the high yield bond market. If companies need capital, they go there. But be aware that when you invest in private credit, you’d better know what you are buying. We think defaults could come down the pipe.

Making an impact through bonds

“Record high temperatures, widespread flooding, significant social unrest, a global pandemic, wars and rumours of wars. The past five years have been tumultuous; the next five possibly even more so. We are a long way from environmental sustainability, social inclusivity, and communal prosperity.

“Around 600 million people worldwide subsist on less than US$2.15 a day². Some 2.2 billion people have no access to safe drinking water³. Half of the world’s urban population have no convenient access to trains or buses⁴. Just over 80% of world energy supply comes from fossil fuels⁵.

“And the vast majority of each of those challenges are found in emerging markets (EMs), home to 85% of the world’s population⁶. Whether you are looking at scale of potential impact, or the scope for positive change, EM is unparalleled.

“The needs are across all 17 of the UN Sustainable Development Goals (SDGs).  Over the next three to five years, we think there are two particularly compelling opportunities in building out affordable renewable energy across EMs and building out telecommunications connectivity, particularly in sub-Saharan Africa. As those projects are completed, we expect new, exciting impact opportunities to arise, helping to drive progress towards meeting more of the SDGs.

Insight Investment emerging market fixed income portfolio manager Simon Cooke

Insight Investment portfolio manager Shaun Casey

Banking on credit

“We can see a path for credit continuing to perform very well, particularly in areas such as investment grade (IG), in the coming months and quarters. We are seeing numerous investors coming into the asset class who haven’t been involved in fixed income for the last decade.

“If you look at some of the yields on credit, we believe we are seeing some of the best opportunities in over a decade, with yields having spiked considerably higher in the last two years. For bond investors, the additional compensation you receive for owning credit over government bonds can be a key factor in any underlying investment decision.

“The banking sector offers some strong potential credit opportunity. Despite some high-profile problems in banking last year, particularly among some smaller US regional banks, we don’t feel these were systemic so much as down to short-term management problems. In our view financial regulators have, on the whole, done a good job since the financial crisis in terms of making banking safer and less risk prone. The sector could therefore offer significant value to select investors.