Remerciements (aux marchés haussiers)

The macro narrative is starting to shift. As the market sees softer economic data and inflation updates coming though, it does not appear to believe there is any need for further monetary policy tightening. But central banks do not want to relax and will try to disavow the notion of rate cuts any time soon. The result is a more bullish bond market, even if cash rates remain high. Yields rose a long way in the second quarter (Q2) and during Q3, so could fall further before the positive mood becomes overdone. With limited market news on the agenda for the remainder of 2023 - and the holidays approaching - the Santa rally has started early.

November fireworks

Bond markets are doing what they tend to do in November - rally. According to Bloomberg, the average total return performance for the ICE BofA US Treasury, UK Gilt and German Bund indices during November over the last 10 years has been 0.62%, 0.94% and 0.57% respectively. Whether there is anything to seasonal patterns of price action in financial markets or not, November 2023’s performance is quite easy to rationalise. The markets, buoyed by a softer US payroll report and modestly lower-than-expected US and UK inflation numbers for October, seem to have taken the view that the burden of proof for the “higher for longer” stance is back with the central bankers. To contradict the markets of their growing temptation to price in significant rate cuts in 2024, the US Federal Reserve (Fed), the European Central Bank (ECB) and the Bank of England (BoE) will need to reiterate their respective policy guidance. Otherwise, bond markets might just get ahead of themselves. The year of the bond might be condensed into two months.

Still high

Cool-headed analysis suggests the cat-and-mouse game between bond investors and central banks will continue. Despite the lower-than-expected outcomes for inflation in October, inflation remains higher than desired. In addition, growth data is not yet weak enough to really squeeze inflation back to central bank target levels. In fact, despite the rally in long-term bonds, rate expectations have only fallen modestly. The end-2024 expectation for the Fed Funds Rate, derived from the Fed Funds futures market, is still at 4.35% compared to 4.80% in mid-October. Similar market pricing for the ECB and BoE shows an unchanged picture for the former and slightly higher expectation of more easing from the latter. Rate cuts: yes, but not early in the year and only partially reversing the hikes seen in the last two years.

Halving and halving again

It is common to hear the phrase that “the last mile will be the hardest” in the fight to restore inflation to target levels. British Prime Minister Rishi Sunak’s claim that his government has halved inflation is about as credible as me claiming responsibility for Sir Alex Ferguson’s 13 English league football championships. Halving UK inflation again, to get back to target, might prove to be as hard as Manchester United winning another league title any time soon (the inflation challenge is probably easier). If Phillips Curves – which show the relationship between inflation and unemployment - are flatter than they have been in the past, then it will take a marked weakening in labour markets to make that last mile. Central bankers think this is required, unless of course the soft landing scenario is delivered by a combination of benign trends in commodities, energy, house prices and wages coming together along with resilient consumer spending. For now, the best assumption is that monetary policy makers will stick to their guns, meaning short rates stay high until 2024 is well underway.

Bonds are OK

That need not put investors off fixed income though. Rates are unlikely to go higher and recent market price action has demonstrated that, given enough yield, there is demand for fixed income. The rapid retreat from the 5% yield in US 10-year Treasuries and healthy demand for the 2043 UK gilt issued on 15 November supports that view. I have written extensively recently about the potential value opportunities in bonds given where yields are and the emergence of a bigger risk premium. It seems that many investors share these views.

Year-end squeeze

On the corporate bond side we are in that period of the year when new supply slows down. Liquidity dries up during the holiday season. A squeeze on credit is already underway. In the UK market, the option-adjusted spread on the ICE BofA UK Corporate Bond index has moved from 170 basis points (bp) in late October to around 150bp at the time of writing. Similar spread narrowing has happened across credit markets, helping strong total return performance so far in November. A lack of supply and strong year-end demand should help credit across both investment grade and high yield markets.

No excess

If 2024 is going to see slower nominal GDP growth and a definite shift in interest rate expectations, if not in interest rates themselves, then it is clearly a more supportive backdrop for bonds. Credit should benefit and the lack of an excessive build-up of speculative borrowing in this cycle suggests only limited scope for credit spread widening if economic conditions really deteriorate. Obviously, there is more chance of spread widening if corporate revenues and earnings come under pressure or there is any evidence of disruption in leveraged businesses. As always, bond investors need to be vigilant about credit deterioration. But from a top-down perspective, credit risk exposure looks manageable.

Risks to earnings

Equity markets have also had a good month so far in November, although most markets remain lower than the level they were at when the Fed last raised interest rates on 26 July. Looking forward it is all about growth. Markets have welcomed the lower inflation data and the easing of bond yields. If it does take more of a growth slowdown to really squeeze inflation, this may be more of a problem for equity markets as it will inevitably show up in slower top-line revenues and pressure on margins if there is still a temptation to hoard labour. Even though we expect slower nominal GDP growth in 2024, the soft landing scenario may be enough to sustain earnings growth. However, the bottom-up consensus for the MSCI All Country World equity universe is for 10% growth over the next year. That is more than achieved in 2023 (so far) with a much higher pace of nominal growth. If those growth estimates are to be met, it puts even greater pressure on artificial intelligence-related technology stocks to deliver. With the VIX volatility index trading below a price of 14 at the time of writing (just in the bottom quartile of observations since 1990), it is cheap to hedge equity exposure and the risk of any deviation from the soft landing impacting the ability of the US equity market to hold current valuation levels. Elsewhere valuation concerns are more limited. Any crack in US equity optimism would mean outperformance of European and Japanese stocks.

Shifting sands

I do sense a shift in macro momentum. In the last few months, the monthly increase in the UK Consumer Price Index has been much closer to the average for each month’s historical price change (between 1990 and 2022) than was the case in each of the last two years. In other words, inflation is normalising. The year-on-year rate is still elevated, but if recent momentum continues, inflation will be lower next year. The bond market sniffs this.

Central banks may be easing into what could be very pivotal election campaigns in the US and the UK in 2024. That is a discussion for another time but the only lasting positive impact of the short-lived Liz Truss government in the UK was to introduce value into the gilt market. Over the last year, the gilt total return index is up 3.3%. The widely followed Gilt 2061 is up 18% over the last month. If we were American, it would be an enjoyable time to give thanks.

(Performance data/data sources: Refinitiv Datastream, Bloomberg, as of 16 November 2023). Past performance should not be seen as a guide to future returns.