Market review
During the fourth quarter, performance was generally positive across fixed income markets. This was largely due to a reversal of the themes that had been in play during the preceding three quarters. The pivotal event in the fourth quarter was the US Federal Reserve (Fed) signalling a change in its monetary policy, bringing to an end the rate hiking cycle it initiated from March 2022. This aligned with market expectations, with rate cuts expected to come later this year.
Before the final quarter, central banks had been focused on bringing down inflation – and this has since been showing signs of easing in both core and headline terms. This is bringing some comfort to investors that inflation is coming back under control and, as a result, financial conditions are likely to ease.
Much of the movement in bond prices we expected for 2024 in fact occurred earlier, during November and December. This was evident in the decline of yields, with US 10-year Treasuries falling over the quarter. This helped bring total returns on fixed income portfolios back into positive territory, with longer-dated bonds mostly outperforming those with shorter maturities.
Generally, there are strengthening expectations that the US and European economies will achieve a soft landing. This would mean inflation returning to target levels without a significant impact on employment and economic growth, which is essentially the best-case scenario. We doubt, however, that all developed economies will be able to avoid a recession during 2024.
Credit spreads have also tightened, so there are clearly growing expectations there will be an economic rebound in 2024. However, forward-looking indicators – such as manufacturing data – have yet to back this up. Likewise, US debt delinquency rates and European corporate bankruptcies continued to increase in the fourth quarter, which also suggests a slowdown in economic activity. Overall, further reconciliation between economic data and financial market pricing is required – there may be further repricing in fixed income markets in the early part of 2024 – before we can be strongly confident about a soft landing.
Fund activity
Over the quarter, the fund generated a positive return and outperformed its benchmark. The currency effect was generally detrimental to performance as sterling exhibited strength relative to most other developed currencies. On a relative basis, the fund benefited from its underweight exposure to the US dollar and Canadian dollar, with both currencies showing weakness during the quarter. We took the opportunity to add more yen exposure during this period, as we anticipated a change in monetary policy from the Bank of Japan which could lead to currency appreciation.
Trading activity was limited during the quarter as the fund was positioned at the outset to benefit from the contraction in yields and credit spreads. The main purchase during this time was a Barclays tier one bond issue, which increased our exposure to financials. We also generally maintained duration on the long side of the spectrum.
Outlook
As financial conditions continue to ease, companies are likely to be able to issue debt at lower interest rates than in 2023. However, economic demand is showing signs of softening, with consumers still dealing with a cost-of-living crisis and wage growth that is unlikely to match the levels realised in 2023. In addition, it is likely that the usual lag between the implementation of monetary policy and its full effects means that 2023’s rate hikes are still to be fully felt across the economy. In addition, as many corporates delayed refinancing their debt to avoid the 2023 hikes, interest rates are likely to stabilise at higher levels than pre-pandemic, which would translate into additional borrowing costs as debts are refinanced.
There are therefore a few potentially painful dynamics that need to filter through the economy before a soft landing could occur. The first half of 2024 is likely to be challenging for corporates and this may lead central banks to cut rates in an attempt to avoid a significant recession. We expect these cuts to start happening around the middle of the year.
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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Promotion approved 11/01/24
