Fixed Income Explained Podcast: Addressing Uncertainty – What’s on the other side?

Peter Marsland: Welcome to Aberdeen's fixed income explained podcast. I'm Peter Marsland, Fixed Income Investment Specialist at abrdn. And this is the last of the addressing uncertainty trilogy that has been our theme for 2023.

In recent weeks, markets appear to reflect the narrative that the Federal Reserve Bank of England and ECB have reached the peak of their rate hiking cycles. So the focus of today's conversation will be on what's on the other side, and what this means for fixed income investors over 2024 and beyond.

Joining the discussion today is Paul Diggle, Chief Economist of Aberdeen's global macro research team, Mark Munro, an investment director focused on credit strategies. And Andrew Stanners is an investment director specialising in emerging market debt. So expertise from a top-down and bottom-up perspective, to help illuminate the road ahead. Welcome, everyone. And thank you for joining me today.

So let's start with the macroeconomic view. And straight to you, Paul. Have the Federal Reserve, Bank of England and ECB actually finished hiking rates? Or is there more to go?

Paul Diggle: So the short answer is yeah, I think they have finished, I would cite three things that point in that direction. So first of all, the economic activity picture. Euro zone and the UK are already stagnating, or maybe even in mild recessions already. Were it not for the small matter of the inflation overshoot, they'd actually be cutting rates already. But certainly, I think they are done. And the US economy has of course, been much stronger. But there are some signs of underlying growth starting to slow into the fourth quarter. Payrolls are moderating a bit. The unemployment rate may soon trigger the so-called Sahm Rule. A weaker 2024 probably lies ahead, potentially a downturn in the US. So that's point number one activity. But then the inflation picture there's been a remarkable moderation in inflation almost everywhere over the past year.

In the US, that's been unusual, because activity has been so strong. So it tells us that there's been some pretty positive supply shocks to the economy. But headline PCE inflation in the US is at 3% now. In the euro zone HICP is 2.9%. And in the UK, which of course for a long time was an inflation outlier. It's come down and it's up 4.6%, all that's, of course, above the 2% targets. But I think the sense is that inflation is moderated a lot and probably can continue to do so. And then finally, the signals from central banks themselves, I think their recent meetings, the Fed, ECB, the Bank of England all added to the sense that they are done, they have not really pushed back hard against market pricing that's brought in rate cuts.

They do want to communicate a bit of a Table Mountain profile, this idea that, although the cuts are done, they're going to be on hold for an extended period. Ultimately, I think they're going to be cutting in 2024. And, as you say, Peter, that's of course what markets have priced in as well. I think the eventual rate cuts could even be a little bit more than markets currently priced. I think in the long run equilibrium rates are still low.

And then remember that a lot of emerging markets are already further along this journey rate hikes were done earlier, real rates reach higher levels. But with inflation now falling rapidly, a number of the EM central banks have already pivoted to rate cuts - the likes of Brazil, Chile, Peru, in Latam, Poland, Hungary in Europe. It's not all one way traffic, but Ems are kind of showing where some of those big DM central banks may eventually go next year. 

Okay, thank you for that. And let's bring in Mark now to look at this environment through a bond lens. So if rates have actually peaked Mark, and we are looking at a rate-cutting cycle to come, what does this mean for developed market credit markets over 2024? 

Mark Munro: Right, Peter, good to be with you. In a nutshell, it's very bullish for developed market credit, especially government bonds and investment grade as well, just for some context. At the end of October, when the narrative in markets was still sort of “higher for longer - Fed might have to do more”. US investment grade had returned minus one and a half percent year to date, which would have been a real shock at the start of the year. November was the biggest month for total returns in the US investment grade since 1982, which is quite unbelievable.

What we saw in November, as has been outlined by Paul in your introduction was the market narrative shifting towards aggressively placing a soft landing and even Fed cuts next year. So growth slowing but no recession and the central banks willing to cut as inflation falls to between 2 and 3%. So we've had  treasury yields falling, we’ve had credit spreads and investment grade tightening. 

And they've now returned 6%, year to date. So getting back to the question, there's been a very high correlation between government bond yields and real yields, and risk assets. In other words, when real yields and nominal yields are pushing higher, risk assets didn't like that credit spreads were widening. But if we’re now at the stage where the Fed has paused and we're going to see cuts, we should see stable to lower yields from government bonds, and we should see tighter credit spreads. That's exactly what the market is doing right now and exactly what the market is trying to aggressively price. That's going to continue for the start of next year, I would expect already the markets trying to price about just over 100 basis points of cuts in the US soft landing will be more I think, as Paul tried to outline there. And as long as that's the narrative credit spreads will continue to tighten. And then it simply becomes a question of how likely is a soft landing and we’ll probably discuss that a bit more to come. But history does tell you that after a Fed pause, and the next year, you tend to see good strong returns from government bonds and good strong returns from investment. 

Peter: Thank you. That's very encouraging. Expanding the conversation to include emerging markets, Andrew, so what's the picture like in your world in terms of rate hikes, rate cuts and the environment going forwards?

Andrew Stanners: Yeah, as Paul mentioned, really, EM markets are broadly a little bit ahead of, of the markets in the cycle. You know and part of that is really driven from historical lessons. As fed cycles began, there can be a reasonable amount of pressure on EM currencies and central banks reacted pretty quickly to that raising rates quite fast. And in a number of cases, they've got pretty decent real rates there now, which provides a carry protection to the currency. And that's been important in preventing secondary shocks, inflationary shocks derived from weak currency. I think the themes of 23 are broadly going to carry on into 24. In that you can see different stages of the cycle in different regions. 

So in in Asia, some of the inflationary pressures that we've seen, haven't really fed through thanks to the influence of China on most of their inflation baskets. But in Europe, we've seen quite a lot of geopolitical pressure, we've seen the gas and energy price challenges from Western Europe. And that's led to quite high growth, high wage demands a bit more of a challenge for monetary policy. 

In Latin America, you see much more of a classic cycle where interest rates were raised pretty quickly, they start to slow growth. And now you have declining inflation on the back of that, and reasonable room for central banks to cut. And I think, I think what we've seen, as Paul mentioned, as starting this year, is going broaden out to other emerging countries, and also perhaps accelerate in the number of the countries that have already started. And the reason for that is slightly lower growth. And definitely, surprisingly, lower inflation at the moment. 

And certainly as we speak, commodity prices are a lot lower than people were thinking at this stage. So a lot of good things happening that mean, the local rates trade continues. One other thing I wanted to say, was also that hard currency bonds will also do well in this environment, as Mark mentioned, you know, in an environment where we're kind of moving towards discovering whether this is a recession or not, you can be pretty constructive for fixed income in general.  So the first half of the year looks pretty constructive for me. 

Peter: Thank you for that. And I just want to sort of, sort of pick up on that point, you mentioned that about recession and sort of circle back to a comment Mark made about the soft landing. So usually, when you go to the end of a rate hiking cycle, and rates being cut, it's usually for a reason. Economic growth could be slowing, but what are the prospects of recession in the US and across Europe, Paul, because I guess there's some different factors affecting those environments.

Paul: So yeah, the historical norm, as you say, Peter is that after large rate hiking cycles, you typically get a recession because central banks often over-tighten. It could well be different this cycle. And in the US especially, there is a path to a so-called soft landing, that the economy can slow. Inflation can be brought back to target and all that can occur without a recession. 

Given the supports to growth at the moment in the US especially from consumer savings stocks, given the benign loosening in the labour market, the positive supply side shocks which have allowed inflation to really moderate very quickly. While the economy is still doing quite well, things like rising participation rates or global goods, disinflation, it all looks pretty favourable. And markets have got quite excited about the possibility of a soft landing. 

And I should say, if the Fed in the end manages to get some early next year rate cuts in, which something markets are trying to price at the moment, that could also be part of opening up the runway to a soft landing. 

However, it's pretty well priced in markets at the moment, arguably too well priced. And I do wonder if it's going to end up being too complacent. The supports from savings buffers are running out. Credit conditions are pretty tight. As I mentioned before, this Sahm rule, which is the kind of if the unemployment rate rises half a percentage point over a year almost always been a signal of recession, that could get triggered pretty soon. 

So I'm starting to see a few cracks. I wouldn't be surprised that those opened up into a slowdown and possibly a mild recession in the US next year. But it's a close call. The story is much more obvious in the UK and the Eurozone. Interest rate hiking cycles have really weighed on growth. The Eurozone contracted 0.1%. I mean, in Q3, it was a tiny contraction. But if you get another tiny one in Q4, you're there in technical recession, the UK is about zero actually if you round it to two decimal places, it's contracting, but it's basically bumping along flat.

I don't think those contractions are going to be especially severe, you know, real wage growth is now positive, again, because of this moderation in inflation, which is going to be a support next year and mean that those economies will do better later next year.

And then there's the story in China. China's post COVID reopening, obviously disappointed somewhat real estate remains a headwind. But policy has eased a lot in China and I'm seeing the first signs of stabilisation in the activity data.

And that tells me actually that the story can be different there. It could be that next year is a bit of an upturn. Yeah, there are long-term challenges. But you know, the people who wanted to speak of Japanification of China, I think that story is overblown. Actually, stimulus is quite supportive at this point. 

Peter: Okay, so still some uncertainty exactly about how the economy may or may not fall into recession in the US or Europe and exactly how deep those positions will be. But turning to you Mark? Just what would that mean for credit markets if we did actually go into a recessionary environment? And I'm thinking particularly around allocating between investment grade and high yield bonds, for example, in your universe.

Mark: Yeah, so just picking up on a point that Paul made there and markets being pretty well priced. For a soft landing, if I was to try and put a number on that looking at interest rates, or rates, markets and credit spreads in the developed market, I'd say we're pricing and sort of 70% likelihood of a soft landing right now. So Paul's point about complacency does start to come into play here. To put some numbers on the spread on US investment grade rate knows 113 basis points over treasuries. And every recession that we've had in the US, that spread has to go to at least 230 to 250.

So you can see you can see the market’s quite buoyant at the moment. If I was to look at better quality us high yield so double B and single B, let's leave the Triple C to one side for now. The spreads are about 330. And then most recessions that's gone above 600, closer to 800 actually. Now, you then get into debates about well, what type of recessions are going to be, how deep is it going to be? Is it just going to be one of those sort of correction type recessions, it's somewhat short lived? And because of the increased structural demand that there is now for credit compared to previous years from pension funds, and from a lot of other investors that are back in the market because there are now yields in play, as opposed to the very low yield world we lived in for a long time, then maybe spreads don't have to go quite as high as those numbers have given. 

But nonetheless, you can see that there's certainly room for quite a bit of spread widening, if we go into recession. Now to your point about allocation between investment grade and high yield. Going back to basics, investment grade, if a recession is to come next year is a better place to be. You maybe have 130 bps of spread widening, you'll have more government bond yield fall to help you so that total returns will still be reasonably positive even in that environment. High Yield is a much more difficult one, spreads will widen a lot more than the government bond yields fall. And therefore it comes down to how deep the recession is. How much default rates increase in that environment. We have a fairly benign view on default rates.

For US high yield sort of mid-single digits, if that was to be higher, closer to 10%, then the returns from high yield are not going to be particularly attractive next year. So we would favour investment grade over high yield. But there will come a point, even if recession hits, that that is a good opportunity for asset allocators to really look for high yield within their portfolios, but probably around the very least a 10% all in yield, I would say.

Peter: Turning to you, Andrew, with the emerging markets, what's the prospect of recession or isolated recession across those emerging market economies? And what's the potential for contagion from developed market recessions into impacting emerging market economies? 

Andrew: I want to pick up very quickly on Paul's comment on China, because I think next year is the year of the dragon, which is meant to be the most auspicious or lucky sign. So maybe China will be lucky next year and have a little bit more of an upside surprise. I think the other the other thing I wanted to highlight related to China is, of course, you know, this year, there's been a lot of talk about how strong the US economy is. And what are we looking at to 2.4% growth. And at the same time, there's been deep concern about China, whose growth has been around about 5%. So still a bit of maybe a market misconception about who's in who's in a strong position here and who isn't. But I fully accept that that's perhaps going down a rabbit hole for discussion another time. But I would say certainly, I'd echo some of Paul's comments that the stimulus is starting to feed through PMIs are kind of 50 ish at the moment here.

So yeah, it'd be interesting to watch, and we can chat about that a little bit more, hopefully, in the podcast, in terms of how EM looks going into 24, you know, I would say fairly resilient, got higher private savings than before, fiscal balances are better than they were in COVID. 

Monetary policy in a number of places, has a decent amount of room to stimulate the economy, there's an absence of excessive credit growth, external balances are pretty good. And with slower growth, it looks like you see external balances keeping relatively flat, as domestic demand falls off and reduces import growth. So no real concerns about the underlying macro position going into next year. You know, the index provider has very helpfully for me, given us some historical analysis on recessions and what it means for EM, in the last couple of days, and they think, you know, it's about 100 basis points of widening in a mid cycle, slowdown. And most of that, if you recall, will come through US Treasuries being lower. Interestingly, as well, mid cycle slowdown, EM FX maximum drawdown is 3%, historically. So a mid cycle slowdown for an asset class that yields you close to 9% is not a problem at all. If anything, you could be looking at double digit returns in that kind of environment. So certainly for the first half of the year, I would say that's the kind of backdrop that the market is going to be dealing with, and you could get some decent returns there. The reason for that really, for me, is that the data is still a bit too early to call, in terms of its definitive path for whether this is a mild slowdown, or something more serious, Paul, and everyone on this call, I'm sure is old enough to remember that we all call for mild slowdowns first, and then discover it's a recession later. But certainly at the moment, I think the data is not compelling enough on either side to give you absolute confidence in how this is going to go.

I think one other thing actually I wanted to say if you don't mind is in terms of actual you know, if it is a serious slowdown, then obviously EM will suffer. But when we look historically, in the last couple events like COVID, and even maybe the banking crisis at the start of the year, the use of balance sheet by the Fed is far more important now in smoothing and muting some of that downside risk. And certainly when you look at those experiences, EM did not suffer as much as he would anticipate in that kind of environment. So that's something really important to keep in mind. Balance Sheets matter this time around, and perhaps mute some of the downside should we get into a deep recession.

Peter: So the base case for 2024 is actually looking pretty positive than these the very simple
motive for the investment case for fixed income in general. However, if there's one thing we're all aware of, it's to expect the unexpected. So what are the factors that could sort of disrupt or surprise, this base case? And what are you sort of not fearful of but wary of happening to disrupt the sort of central thoughts that we have on the outlook?  

Paul: Yeah. So I think the biggest risk scenarios I see around this baseline view of mild contraction, the US that's pretty bullish for fixed income, is actually an upside risk, economically speaking, which is a soft landing, that we've also been talking about, which could also mean a rebound in the UK and the euro zone, it could mean, you know, a much stronger Chinese economy amid the stimulus we've been talking about, actually, you know, a lot of these risks have skewed upside macro economically, you can motivate this kind of scenario by the ongoing positive supply shock that clearly has played out in the US things like rising participation, higher productivity growth. In Europe, you could motivate this upside from support to household consumption by the return of positive real income growth as inflation moderates, but wage growth is still pretty strong. In China, you can motivate it by stimulus is going to cause an even bigger upturn in the economy.

I would note that some of that positivity, aspects, of that is embedded in market pricing. As we've been discussed, we've been discussing. On the downside. I am certainly concerned about escalation of the conflict in the Middle East, which could cause a large upward shock in oil prices, I think there are a lot of diplomatic guardrails that can prevent that. But in terms of looking for a potential inflationary shock, we know that it can come from geopolitics, and it can come from energy. And central bank's ability to look through energy price shocks in the way that they might have done historically, is reduced now after the experience of high inflation over the past few years. It's also possible that the benign moderation and inflation over the past year doesn't continue to it could be that the last mile of inflation that people call it is the hardest. And that can be because well, a lot of what's happened so far is favourable base effects, easing global supply chain problems, you know, and those are kind of easy gains, so to speak. And amid still pretty tight labour market strong wage growth, perhaps we don't we kind of stall out at 3%. And don't get back to 2%. That's certainly a worry that central bankers have. And that's why they talk about Table Mountain profile for interest rates, keeping rates restrictive for longer.

Stepping back a bit, I'd make two overarching points. As you said there in the question, Peter, you've got to think about scenarios, the market prices scenarios, the world is uncertain. So I think the scenario lens is the right one to come at it. And then secondly, no doubt there will be unknown unknowns, you know, things that we haven't even thought about that will that will change the story. And that's why it's so interesting in markets and macro, right? 

Peter: Oh, indeed, I don't think it's ever been more interesting, to be honest. And so the taking it down from a top down view to more bottom up, Mark, what are the potential potholes that you see on the road from a credit perspective? 

Mark: Yeah, it's quite interesting what Paul was saying there because you know, Paul's base case is sort of for a small contraction in the US next year, thinking about the market for now the market isn't thinking that way in terms of his behaviour right now, and its exuberance. So credit markets are not pricing, a recession in the US next year. So just the recession, even a small one will be a bit of a shock to the market's base case, right now, even though it possibly wouldn't be a shock to any of us in the podcast. 

But one of the bigger risks and I do agree with Paul here as well is that the US economy remains incredibly resilient. And the market then starts to think back to this higher for a longer tabletop mountain type environment. That could potentially be quite toxic further out for developed market high yield, because in 2024, and 2025 25%, of the European high yield market is maturing, and will have to be refinanced in the market. That's a very high number. It's quite weighted to 2025. If we get to the end of 24, and a lot of companies are thinking about refinancing in the market, and interest rates are still high, the market is pricing in still sticky inflation. It's going to start to be quite painful for a European high yield issuers to have to issue debt at these higher yield levels. Plus the fact that this kind of higher for longer will necessitate it by itself, higher odds of a recession further out or a deeper recession potentially further out. So you put these two things together, it’s quite toxic for develop market high yield towards the end of next year.

Now, it's not our best case, from all the scenarios that we've discussed, I think for any of us, but that's just one of the one of the things to mention.

Going much more micro policy this as well, it's always very difficult to predict, or breaks. You know, nobody would have thought about regional US banks this year or Credit Suisse falling over just on a crisis of confidence. That seemed outlandish, but it happened. 

And actually, you know, real estate's been a really difficult sector for a long time. But real estate actually could be a sector, that surprises massively on the upside with more stable yields. And it's still difficult macro environment. So, you know, we continue to do our credit work, but it's always very difficult to put your finger on exactly where the landmines are from a micro perspective. 

Peter: I can certainly understand that. And turning to you, Andrew with emerging markets. I mean, it'd be a surprise, if there are no surprises across the emerging markets, it does tend to throw up the occasional interesting story, anything that's particularly on your radar at the moment as a concern?

Andrew: Yeah, I think I think the important thing for next year includes DM is something like two thirds of the world of voting next year. So election risk is very high. And okay, we have the UK, I'll let you do that in another podcast. But later in the year, the markets are definitely going to focus in on whether Trump is running. And that can mean a lot for 25. Again, that sounds like another podcast for another time, in EM space. So we've just had Argentine elections, again, a bit of a surprise there. We've got a couple of geopolitical ones coming up, we've got Ukraine, and we've got Taiwan now, things have thawed a bit with China. But if Taiwan elections go a different way, you maybe get someone a little bit more anti China, and that can stir up some of some of the issues that appear to have abated there. And we've got big populations going to the polls, Indonesia, India, Mexico, these all should be relatively straightforward. 

But somewhere like South Africa, where the ANC majority is potentially at risk, which is quite a change from the last two decades, could be of interest to markets. And then on top of that, you have smaller markets that aren't necessarily going to affect the global risk environment. But there are a few countries that are looking to engage in IMF programmes that tried to return to current are trying to avoid defaulting and changes in the presidency there could change that outlook. So countries like Tunisia, Ghana, Mozambique, and interestingly Venezuela who are very topical at this time, potentially coming up. So it's a really interesting year from an election point of view that will sadly, always throw up some surprises, even if it's just in the UK, which I'm not calling I'm not calling that. But in other things to think about - issuances much lower part of that is due to access to the market, which could change so we could see an increase in issuance if the Fed and US rates go lower.

We talked about China already. The savings levels there are still quite large, you know, the investment into the housing sector that was their go-to is no longer there. Could they invest in US Treasuries? Could they be the new marginal buyer? We’ll have to wait and see. Defaults in EM. Probably we would say there are no defaults next year. We’ve got Ethiopia who may default on 11th December (if this goes out after you’ll know). But otherwise next year it looks like most will muddle through. A lot of that is coming from greater interaction from the IMF allowing greater access to funds there. 

Finally from me, the backdrop for fixed the volume looks pretty good certainly for the first half of the year as we try and work out what we’re going to face, particularly in the US. Room for more central banks s to cut locally, FX looks ok at this stage. The dollar bonds look pretty interesting in terms of very attractive carry entry level, certainly in 20 plus years, I've been looking at the markets this is an amazing entry level. 

And I think, you know, the marginal surprise could be how much better performance is should people start thinking about duration. A lot of people are in short instruments, they're in cash, they're in money market. If you start getting that fear that you need to lock in longer duration yields. Then you could see people returning to fixed income in general, which I think would be incredibly positive for prices. 

Peter: I think that's a good point about embracing that duration sensitivity. And moving out of the safety of cash could be a definite theme that rewards investors over 2024. Thank you for that. That's really interesting.

So we're running out of time, because we've had such interesting content to discuss today. So it's been a really good conversation. But before we wrap up the podcast, the festive period is bearing down upon us.

And with that festive period comes an array more uncommon food and drink items. So just to wrap up very quickly, which of those festive food or drink items do you particularly enjoy? 

Or which could you actually do without and banish forever? So I'm going to start this off. So I'm going to say, I'd like to banish bread sauce, because I think it's absolutely pointless and tasteless, and takes up valuable space on a plate. So I'm going to say bread sauce, no, thank you very much. Andrew, shall we kick off with you? 

Andrew: Sure, absolutely. I'm sorry, if I'm taking this off anyone else? But speaking on behalf of EM, I would say, turkey is not for the rest of the year. So only have it at Christmas time. Don't consider that next year. But what actually, you know, seriously. So my sister in law is from Bogota in Colombia. And, you know, they have a very different Christmas meal. So I would be grateful for the Christmas traditions that you have, that you're happy with, probably for the main apart from bread source. 

But one of the things I'm quite tempted to get involved in probably at Christmas time, and all year round is something called Buñuelos. It's like a small doughnut that can be sweet or savoury. So I think the cheesy message if you don't mind me saying so would be have a little bit of EM in your Christmas meal, but also throughout all of next year.

Peter:  Thank you very much. Paul?

Paul: So I tend to think if you only want to eat it once a year, it can't be that good. And I extend that to Turkey to Christmas pudding, maybe even to mulled wine. But the thing that makes an appearance every Sunday in our house is cranberry sauce. That is year-round. 

Peter: Good stuff. I concur with that one and Mark. 

Mark: I have to say, I agree. I love cranberry sauce. I've never had bread sauce. That sounds utterly pointless, Peter. And I quite like sprouts with the right sauce. It's probably not very festive, but anything that's got turnip, or anything like sweet potato. Not for me, not for me. So you just leave that at a Christmas. 

Peter: Very, very interesting. Okay, well, that leads me to say thank you very much to all of our guest speakers today, I thought was really informative. Really very topical. So thank you very much indeed. If you'd like to find out more about Aberdeen's latest fixed income views, you can subscribe to our fixed income newsletter by clicking on the link below. And you can also access previous podcasts, the other two episodes in this trilogy, by also clicking on the link below. And thank you very much to our listeners. And we'll see you in 2024. Thank you.