IN FOCUS6-8 min read

Outlook 2024: Normality is returning to fixed income, and investors stand to benefit

With cash rates now peaking, yields on offer in fixed income are particularly appealing. Yields are the highest they’ve been in a decade, attractive versus cash and very attractive versus equity dividend yields.

30/11/2023
Outlook Fixed Income
Read full reportNormality is returning to fixed income, and investors stand to benefit
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Authors

Stuart Dear
Head of Fixed Income

2023 has been a strange year for fixed income. After the rapid repricing of 2022, many expected 2023 to be a year of relative stability. However, volatility remained elevated and yields continued to move higher, particularly for longer maturities.   

At long last, with the end of the hiking cycle in sight, normality appears to be returning to the asset class. Elevated yields now offer compelling income, providing a good base for total return as we move into the new year.     

In this outlook for 2024, I discuss the investment implications of higher yields, the structural trends driving the market, and where we’re seeing the best opportunities across the fixed income universe.  

Attractive yields

With cash rates now peaking, yields on offer in fixed income are particularly appealing. Yields are the highest they’ve been in a decade, attractive versus cash and very attractive versus equity dividend yields.

FI Outlook graph1

Elevated yields form a great base for good returns over time. They can also provide an excellent buffer for returns against price volatility over short periods. We believe high quality fixed income currently offers an excellent entry point - offering attractive yields, with limited downside and potentially material upside insurance for portfolios.

Uncertain cycle but Fixed Income can provide cover

Despite the aggressive hikes of central banks since early 2022, the economic cycle hasn’t yet weakened dramatically. Corporate profits have softened but not collapsed, labour markets have only loosened marginally, and inflation in services remains high.  Ongoing strong fiscal spending, particularly in the US, and elevated savings that consumers could draw upon are two key reasons for cycle resilience to date. In Australia, strong net migration has helped boost aggregate demand and maintain inflationary pressure.

Several covid-induced distortions (including supply-side disruptions, the outsized policy response, and shifts in demand behaviour) make this cycle harder to read. We expect a continued softening in economic activity, and ongoing moderation in inflation to still uncomfortable levels. The likelihood of a mild recession is high, but with a wide range of possibilities around this.

We have modelled a number of cycle scenarios to estimate the impacts on our portfolios. Scenario analysis reveals that even in the cycle scenarios that are more adverse for returns, elevated starting yields provide a strong offset to price moves.

FI Outlook graph2

Our bias is towards the more positive scenarios for fixed income returns in 2024, supported by the imminent end of the tightening cycle in most economies. At this stage our central view is not for deep recessions and very aggressive central bank easing. Two things we are watching most closely to assess cycle progression are: 1) the extent of moderation in services prices and 2) signs of weakening in labour markets.

A new regime

Looking past the current cycle, we believe three structural themes will underpin a shift in the economic regime away from the low inflation / low rates / low macroeconomic volatility regime experienced post-GFC.

  1. Geopolitical tension: This will reinforce increased spending on defence, both in physical military capability and in cyber security; and the shift towards onshoring, or ‘friend-shoring’, in order to secure supply of critical food, energy, technology and medicine.
  2. Climate transition: Transitioning energy generation and distribution from carbon-based to renewable sources, reconfiguring the remainder of the economy to be more energy efficient and resilient to more volatile weather, and sourcing the required materials, is expensive and disruptive.
  3. Social awareness: Demographics and community expectations to meet increasing housing, medical and other support needs imply large ongoing spend on social infrastructure. Whilst pension and tax systems are attempting to address part of the funding requirement, the burden is increasingly falling on government.

Given these structural themes, the next economic regime is likely to look significantly different to the last decade in several key ways: 1) Inflation will be more challenging to contain, as much of this spending will not improve productive capacity, 2) Fiscal policy will be more active and dominant, with monetary policy more contained to limiting inflation, 3) Macroeconomic volatility will be higher.

Sound portfolio structure and active management is required to navigate this possible new regime. Three key ideas for fixed income portfolios are to:

  1. Emphasise income, focusing on dependable cashflow generation. There will be a role for duration as a diversifier, in cyclical downturns rather than through the cycle.
  2. Seek inflation protection, both via the cashflows of securities (eg own inflation-linked bonds), and the cashflows of underlying business (own sectors with CPI-linked earnings, or pricing power).
  3. Strategically limit exposure to macroeconomic volatility, but tactically manage exposure. At a corporate level, companies with attractive valuations, high quality earnings and the ability to benefit from regime shift thematics are preferred. At the macro level, limit exposure to higher volatility segments of the yield curve.

Key portfolio positions

Taking into account our 2024 view that yields offer good value for an uncertain cycle, and our longer term structural themes of persistently higher inflation and greater macroeconomic volatility, our key positions are:

  1. Overweight investment grade credit, particularly in Australia. This is a key way investors can access income from high quality assets at a reasonable price, and an attractive way to build inflation resilience via sectoral exposure to infrastructure, utilities etc. We also like Australian bank subdebt, which, for us, sits in a sweet spot for return versus risk in the capital structure given the strong Australian banking sector, but are cautious on riskier global credit.
  2. Moderately overweight interest rate (duration) risk. Despite cycle uncertainty, yields appear to be peaking with the final hikes being delivered. We will increase duration as/if the cycle turns.
  3. Overweight inflation linked (ILBs) versus nominal bonds. ILBs are currently delivering higher income in the near term, given sticky inflation, and can provide longer term protection against inflation.
  4. A preference for shorter tenors. This is particularly the case in the US and Europe where short dated yields are higher than those on longer maturities. In the longer term, greater macroeconomic volatility should result in a rise in term premium in longer maturities.
Read full reportNormality is returning to fixed income, and investors stand to benefit
4 pages886 KB

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Authors

Stuart Dear
Head of Fixed Income

Topics

Australia
Australian Fixed Income
Stuart Dear
Fixed Income
Bonds
Outlook 2024
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