Shaken not stirred: Income and quality sensible amidst uncertainty

Third quarter (Q3) returns were spectacular by fixed income standards, mainly due to more bullish US interest rate expectations. A repeat of this is unlikely but all the risks that the market is currently focused on suggest the bid for bonds will remain. Volatility is picking up even if the soft landing macroeconomic backdrop looks more secure. This will bring potential investment opportunities as prices get pulled between solid fundamentals and high levels of uncertainty. A focus on income and quality look to be sensible investment themes for the run into year-end.

Mr Bond, we have been expecting you

With cash rates falling and bond yields still having some room to decline as the easing cycle continues, fixed income remains interesting for investors. Of course, if you are concerned about a US recession or an escalation of the Middle East conflict, bonds look interesting. I have said for some time that 10-year US Treasury yields are in a fair value range and in recent weeks have stabilised in that 3.75%-4.0% range. But they can still go lower if the market has a risk-off episode.

More neutral

Sticking to the core cyclical outlook – characterised by the expectation of a soft landing – it would be logical to think the best returns from fixed-income markets are behind us. Recent performance has been driven by a big re-pricing of interest rate expectations relative to a few months ago. 

The implied end-2025 three-month US dollar interest rate (taken from futures market pricing) has declined from 4.7% at the end of April to 3% today. Without clear signs of a recession, another such decline in rate expectations is very unlikely. The yield on the benchmark 10-year Treasury would need to decline to around 3% to get an equivalent total return. I get a sense that investors have shifted to a more neutral stance on rates.

Pushbacks

My reading of the market is that rate expectations are consistent with a soft landing and with central bank interest rates going back to neutral in 2025. The pushback to that scenario has two main themes. The first is that we cannot rule out a recession – although no one has a clear view of what might cause one. There are concerns about the stock market being in a bubble that might burst. There are concerns about credit conditions deteriorating because of “irrational exuberance” – an upturn in lower-quality borrowing as rates come down. There are also concerns about a slow-burn recession as the labour market gradually weakens and that the weakness in the manufacturing sector pervades the broader economy.

Oil (still) important

Human nature tends to worry about what can go wrong. The intensification of the conflict in the Middle East tells us that something can come along to upset the apple cart. This is something that could disturb rate expectations, through the potential impact on growth and inflation, should the global oil supply chain be affected. Oil markets are starting to reflect the potential for Israel to attack Iran’s oil facilities. Oil is less important than it used to be, but we saw in 2022 what an energy price shock can do to global inflation and growth.

On the sidelines

One client said to me “we are in a wait-and-see market”. Waiting to see if either fiscal-induced inflation or a recession is a more likely scenario in the US, than the Goldilocks one which is currently priced in. Waiting to see the result of the US election, what happens with Iran and Israel, how Europe’s political landscape evolves and whether the big policy announcements from China will break the downward debt-deflation spiral. On that we are sceptical and, given the huge increase in equity prices in China since the monetary easing, the value opportunity has gone anyway.

Credit is rewarding

Wait and see and clip the coupon. If yields are going to be anchored to the monetary path that reflects the consensus, then the extra yield from credit should be harvested. In the US high-yield market, defaults remain low so the yields on offer still more than compensate for potential losses, in our view. In high-grade credit, why not go for the additional 110-120 basis points (bp) of yield in the lower-rated part of the US investment grade market or the 105bp of additional bond yield relative to swaps in the euro market? 

An allocation to high yield brings an all-in yield at the index level of 6% for the euro and 7% for US dollars. For the equity investor, I just have a feeling that Q3 earnings are going to be good for technology stocks with commentators seeming to be excited about the new Apple iPhone and Nvidia’s microchip pipeline.

Income and quality

There are a lot of risks. Timing market moves that might respond to these risks is difficult. Credit default swaps indices, the VIX equity volatility index and US break-even inflation rates have all moved higher in the last couple of weeks. 

It is not a big call to suggest that volatility will be higher in the remainder of the year given all the geopolitical uncertainties. Income from bonds and quality exposure in equity markets are sensible investment themes in such an environment.