15 Nov 2023
A soft landing or a hard landing? As we look to 2024, markets are still searching for an answer to this key question. In the minds of many investors either of these two very distinct outcomes has a high probability of occurring. Yet they would lead to diametrically opposite asset allocation decisions, so trying to solve categorically in favour of either could leave one exposed to substantial risks in the event of being wrong.
Given the unusually elevated macro risks on the horizon, we believe a focus on a high-quality, predictable stream of returns works in both scenarios. We find this in fixed income. The asset class is again providing both capital preservation qualities and a high level of income, a role it had relinquished in the immediate aftermath of the Global Financial Crisis and the ensuing central bank financial repression.
Let’s look at the possible implications of the two most-commonly quoted macro-outcomes for 2024:
In a soft-landing scenario, growth would be relatively modest, but not negative, while inflation would likely be contained at around current levels and/or still modestly declining. In this case, we assume there would be minimal room for interest rate cuts in the US, and probably only towards the tail end of 2024. It is reasonable to expect some modest rate cutting, as according to the Fed’s own account, monetary policy is already restrictive.
In this scenario, both fixed income and equities would likely do okay. Interest rates would probably fall somewhat, while credit spreads across both investment grade and high yield would likely rally as we price out a recession / reduce the realized default rate. Equities would also benefit as financial conditions ease and corporates make use of relatively cheaper funding, while demand remains in place due to firm employment.
In a hard-landing scenario, growth would be negative, demand would fall and with it, employment as well as inflation. In this environment government bonds would likely perform best, as central banks would be forced to ease materially. Investment-grade credit would fare second best relatively (inherently not a default risk asset class), while high yield and equities would fare worst, owing to depressed revenues and a rise in defaults.
Clearly, two very different sets of outcomes for risk assets, both with a non-trivial probability of occurring. This is one of the most uncertain environments that many investors have faced in a while. It also inherently comes with many lucrative opportunities down the line, if navigated correctly.
In that regard, an allocation to fixed income offers arguably the best risk-adjusted return potential that it has had for some time. The asset class currently offers access to historically elevated levels of yield, without over-committing to a binary outcome. At current levels, bonds have two distinct advantages:
Investing in bonds has traditionally been a conservative asset allocation decision. Their place in an overall portfolio was to provide a steady stream of recurring income, with the benefit of capital preservation. Since the Global Financial Crisis in 2008, global central banks embarked on a massive quantitative easing, which has also colloquially become known as ‘Financial Repression’. The process killed bonds as a natural source of income in investors’ portfolios. This has now changed, and we can again obtain income from allocating to fixed income.
The return of income is evident from the yields on the US investment grade credit and US high yield indices. As global corporate bond yields have more than doubled in the past two years, they now offer another rare and unique characteristic – yield that are higher than equities.
As Chart 1 shows, comparing the yields on the investment grade corporate bond and high yield indices with the earnings yield of the S&P 500 reveals a market opportunity that occurs very rarely and doesn’t typically last very long. This is the ability to de-risk one’s portfolio by moving up the capital stack from equities to bonds, while picking up yield along the way.
Chart 1: Yield-to-worst of US fixed income relative to US equities (%)
Source: Aegon AM. From 16/9/2010 to 16/10/2023. Indices are S&P 500, Bloomberg US Corporate Index and Bloomberg US Corporate High Yield Total Return Index.
This is why we find bonds so interesting at present. We do not pretend that we have a perfect foresight as to which macroeconomic outcome is most likely to transpire. However, we also want to be alive to the attractive market opportunities that this uncertainty brings. Weighing the balance of probabilities from a risk and reward perspective, we find fixed income to be as attractive as it has been in well over a decade.
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