Market review
The third quarter of 2024 was positive for fixed income returns as central banks in the UK, the US and Europe began or continued to cut rates as inflation moved closer to its 2% target rate. At the same time, central banks' focus turned towards supporting the economy as the higher interest rates were assessed to be too restrictive on growth and employment.
The US economy has been growing robustly and in the second quarter US GDP growth came in at 3.0%, up from 1.6% in the first quarter. There are signs of a softening labour market and a slowing down of the US economy, but the US is nowhere near recession.
The picture is quite different in Europe, with Germany and France on the verge of recession. Both these core European economies have been particularly hit by the slowdown in China, one of their key export partners. With this clear weakness in key European economies, the European Central Bank is under greater pressure to cut rates and to do so sooner than had been expected.
Against this backdrop, fixed income spreads tightened only slightly, led by those sectors that are key beneficiaries of lower rates, such as real estate, and other sectors that had underperformed last year, such as financials and subordinated debt.
Overall, corporate market performance has been very benign. Returns have been supported, however, by the sharp fall in government yields, contracting in Europe by 20 to 50 basis points over the quarter and, for US Treasuries, by 50 to 100 basis points.
Fund activity
During the period, the fund produced a positive return that underperformed the benchmark. Notable purchases over the quarter include French real estate group Unibail, while notable sales included taking profit in some of the short bonds that had outperformed, such as Gatwick Airport and Italian banking group Intesa San Paolo.
The fund is sterling-denominated and unhedged for currency fluctuations. Over the quarter, the UK currency proved strong on foreign exchange markets as inflation in the UK remained stickier than in other markets, so limiting the Bank of England’s ability to cut rates.
The exception to this was Japan, which raised its central bank rate, and the Japanese yen was the only currency to rise in value against sterling over the quarter. The fund has an underweight allocation to yen, and this was a drag on relative performance. However, our overweight position in sterling-denominated bonds was a relative boost to returns.
Outlook
There have been strong tailwinds for fixed income returns, which were further supported towards the end of the quarter by the announcement by the Chinese government of an unprecedented level of stimulus to boost domestic consumption and avoid a collapse in China’s property market. We expect the global economy to be supported in the next quarter by that stimulus and the lower level of interest rates in the UK, Europe and the US which will ease the cost of debt on both companies and consumers.
The key risk to that outlook is tensions in the Middle East, which could lead to an inflationary shock from rising oil prices. There are also risks around the US presidential election. Regardless of who wins, there is the likelihood of increased government spending. In the event of a Trump victory, there is also the possibility of increased protectionism, which may be inflationary.
With the debt-to-GDP ratio above 100% for most countries in Europe and annual budget deficits way above limits set under Eurozone rules, government debt is the key uncertainty. At some point, European governments will need to pare back spending, but at the moment such cuts are not politically palatable. The longer that persists, the greater the risk that investors lose confidence in some European issuers, triggering an increase in yields. We have started to see some signs of that effect in France, although so far it has remained fairly well-contained.
Important Information
The value of investments may fall as well as rise and investors may not get back the amount invested.
The views expressed in this document are those of the fund manager at the time of publication and should not be taken as advice, a forecast or a recommendation to buy or sell securities. These views are subject to change at any time without notice.
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