Fixed Income Monthly - October 2023

The Fixed Income Monthly provides a forward-looking summary of the medium-term views from Fidelity’s Fixed Income team. Our investment approach is multi-strategy, with portfolio managers given clear accountability and fiduciary responsibility for all investment decisions in a portfolio. Given this portfolio manager discretion, there may at times be differences between strategies applied and the views presented in this document. We believe in managing portfolios with a mix of active investment strategies, including top-down and bottom-up, such that no single strategy dominates risk.

Outlook

The economy is proving resilient, and soft-landing hopes are rising, but positive headline data conceal a more nuanced picture. Composite flash PMIs for developed markets have ticked lower for the past month and imply either stagnant growth or a mild contraction.  

In the US and Japan, PMIs were lower but still in expansion. The growth profile of the US remains sufficiently uncertain to lead us to conclude that a recession is more likely than not. In Europe, the PMI is stuck in contraction, which supports our view that Europe is on the brink of recession. We expect to see no growth in Europe in Q3 and a contraction in Q4. 

While growth slows, inflation remains elevated. Despite this, central banks are now pausing rate hikes, but it is too early to call a definite end to the hiking cycle. While the ECB may be there, the Fed and Bank of England could have more hikes in store. Further rate rises will depend on the data, but the stickiness of inflation could force their hand. 

This higher for longer scenario is starting to be priced in by the market. The yield curve inversion has moderated and the 2s10s now stands at -41bps having begun September at -88bps. The long end has been sold off, indicating that markets are adjusting to rates remaining high.

Yield curve inversion moderates in September

There are also signs that tightening monetary policies are not feeding through to the economy as quickly as hoped. Many companies, for example, are earning interest on their deposits but not yet paying extra on debt issued at ultra-low rates during the pandemic. One exception is smaller companies, which are starting to pay meaningfully higher rates. However, this could change as larger firms begin to refinance next year.

Smaller companies feeling the pinch of higher rates

Given that we believe the US is moving towards recession and Europe is on the verge on one, we maintain our overweight duration positions. Nonetheless, in the short term, US yields could yet move higher given the substantial Treasury supply expected due to US fiscal deficits and the higher for longer mantra from the Fed. However, we think in the longer term, US yields will compress.

In the UK, we maintain a flat weight on duration. The day after a surprise fall in the August UK CPI, the Bank of England wrong footed markets with a rate hold decision when a 25bps hike and potentially another at the November meeting was expected. This hike has been priced out further into the future and gilts have outperformed as a result. But there are headwinds to an overweight gilt position. 

The BoE’s announced £100 billion quantitative tightening programme beat expectations, partly reflecting the central bank playing catch up after it under delivered on its previous QT programme due to the LDI crisis. This higher QT will weigh on bond prices. We are also starting to see overhangs in bond auctions; a sign that the market is finding it increasingly difficult to digest new supply, which will be exacerbated by deficit funding required next year.

Outlook

September was a challenging for inflation-linked bond markets. In Germany and the US, 10-year real yields reached decade highs at 2.23% and 0.45% respectively, as investors priced in a higher for longer environment. The UK was an outlier, with 10-year real yields unchanged at 0.59%. 

The UK’s September CPI print was encouraging and drove real yields lower. Most notable was the decline in core CPI which, at 6.2% yoy, was 0.7ppts below August’s print and 0.6ppts below expectations. Core services led the decline as wage growth started to moderate and supply chain pressures continued to ease. 

The print reinforces our view that there are no structural differences between UK and US inflation (aside from the UK’s delayed monetary policy response), so we continue to believe that UK inflation could fall. However, valuations relative to the US look stretched as UK real yields outperformed in September. As such, we took some profit on our UK real duration position and reduced our long position. 

US 10y TIPS fall versus UK inflation-linked gilts

In the US, headline CPI was slightly ahead of consensus at 3.7% yoy, and higher than last month’s 3.2%. However, this was partly due to seasonal effects such as airfares, and core inflation fell 0.5ppts to 4.3% yoy. This was led by core goods, where used car prices continued their steep decline. Core services remained elevated at 5.7% yoy, but we see scope for more declines in core inflation. Forward looking survey data continues to soften, and there should be further support from declines in OER, which slowed to its smallest increase in two years. The selloff in US TIPS provided a very attractive opportunity to add to our long position. We focused on adding real duration at the short end, given the risk for late cycle curve steepening. 

September’s European HICP prints were mixed. Euro-area core HICP fell to 4.5% yoy from 5.3%, but individual country prints were varied. Spain saw a reacceleration in headline HICP while Germany saw significant declines. However, much of the decline in Germany was due to the €9 transport ticket offered through the summer of 2022. This drove June and August 2023 inflation higher, but left the base effect in September. 

We remain neutral in European real duration. Potentially higher supply before the end of November could act as a negative technical and valuations screen very rich relative to US real yields. .

Breakevens drifted higher through September, with both the UK and US 10y breakevens increasing around 0.1ppts as nominal yields sold off. German 10y breakevens were more muted, finishing unchanged. We have trimmed our long US breakevens, short European breakevens cross market trade to take profit, but remain comfortable with the position. 

US inflation should be structurally higher than Europe given the higher weight of rentals in the data. This skews inflation towards housing services that tend to grow with wages. There is scope for this trade to continue to perform. 

Euro long-term inflation expectations should trade inside the US

Outlook 

Global investment grade corporates returned -1.8% in September with spreads broadly unchanged. This negative performance was predominantly caused by a sell-off in global government yields, while no significant move was observed on the corporate spread basis. Regionally, US IG was the main underperformer, while Sterling IG was the best performing IG asset class as Gilts beat US Treasuries. Overall, we remain neutral on global corprorate spreads.

Our focus remains on the state of the global consumer, and we are closely watching developments on several fronts. The decline in live data, such as search engine requests for plane tickets and new cars and slowing OpenTable bookings, indicate deteriorating consumer health. We are also cognisant of resuming student loan repayments and elevated oil prices globally. These factors will weigh on discretionary spending in the coming quarter.

Higher oil prices are weighing on global consumer

US IG corporates returned -2.5% in September with spreads widening by 3bps. September proved to be an expectedly busy month for supply. However, overall volumes were not particularly overwhelming given the absence of large M&A deals and overall rates volatility. We remain cautious on US IG on a spread basis, and are therefore biased towards less cyclical sectors that should be more insulated from a US macro slowdown. However, the value of US IG all-in yields remains very attractive and we are therefore neutral on the asset class.

Euro IG corporates returned -0.9% in September, with spreads moving 4bps tighter. Real estate tightened significantly during the month, while autos lagged the broader move and ended up closing wider. Notably, corporate spreads proved to be resilient in light of higher supply. As a result, we are optimistic on Euro IG into year-end, given valuations are still pricing in a relatively high recessionary buffer.  

Euro IG valuations relatively attractive versus stocks

Total returns in Sterling IG corporates were flat in September, with spreads also unchanged. Real estate again was a top performer. Overall, we are neutral, and we continue to move up in quality given our concerns on the macro outlook over the medium term. 

Asia IG corporates retuned -1.3% in September, while spreads tightened by 6bps. Although corporate spreads in Asia are already looking fairly rich on a historical basis, we have seen relative improvements in Asia’s credit fundamentals over the last 5-10 years. We are focused on capturing higher yield at the front end of the curve without increasing the overall credit exposure.

Outlook

Global high yield returned -0.7% in September in local currency and spreads widened by 9bps. This was amid fiscal concerns and worries over higher for longer rates. Although the fragility of the market is rising, broader leverage and corporate fundamentals remain healthy. Deleveraging since Covid has helped, but if that stalls spreads do not offer much cushion. Furthermore, higher rates mean refinancing risk, and we should expect pressure on weaker balance sheet issuers in the long run. That said, yields on offer in HY are attractive without the risk of significantly high default risk. We maintain a neutral stance. 

US HY returned -1.2% in local currency terms and spreads widened by 18bps. The Fed indicated that we are broadly at the peak for interest rates, so attention will begin to turn to how long rates will stay at this level. US HY spreads are close to their 10-year lows. The path of rates adjustment may be less significant than its timing; abrupt moves higher in rates will drive spread correlations out of negative territory. 

Meanwhile, markets have reopened and there has been an uptick in primary activity. Thus, despite the spread tightening we have seen this year, we retain our neutral positioning on US HY as favourable debt metrics, balanced technicals, and attractive yields and carry outlook will help drive excess returns for the remainder of the year. 

US HY spreads continue to tighten

European HY returned 0.3% in euro hedged terms, and spreads tightened by 5bps in September. Fundamentally, there does not yet appear to be a negative ratings drift with more rising stars materialising compared to fallen angels. 

HY/IG metrics are also close to their historical averages, such as the BB/BBB ratio and Xover/Main ratio, which suggest that IG markets are not particularly attractive compared to HY. Given interest rate rises, financial leverage ratios will be affected and interest coverage ratios will drive credit ratings going forward, but overall maturity walls remain well addressed. 

New issue markets seem to have re-opened but there is a lack of new issue premium, which indicates ambivalence between the primary and secondary market. Although spreads have compressed, yields have risen, but we are still positive on EHY as volatility remains fairly contained, default data is still benign, and carry will continue to drive returns.

Xover/Main ratio close to historic average

Asia HY returned 0.9% in September in local currency terms and spreads tightened by 53bps. Earnings have been mixed but overall slightly positive. Stimulus from China is encouraging but we anticipate only a moderate effect on economic performance given the conservative tone set by the authorities. Unlike the rapid rally observed post-reopening, the impact of these policies is likely to be uneven across different industries. We therefore maintain our neutral stance on Asia HY.

Outlook 

Emerging market debt struggled in September with all three sub-asset classes posting negative returns. Emerging market local currency debt (-3.4%) underperformed hard currency sovereign (-2.6%) and corporate debt returns (-0.8%). Negative FX returns were the main driver of local currency underperformance, while rising US Treasury yields constrained hard currency returns.

Local currency duration has been one of our highest conviction areas for most of the year amid expectations of falling inflation and easing monetary policy in EM. This expectation is slowly being realised with CPI in most EM countries now below peak levels. Some EM countries have started to cut rates, with more expected to follow before the end of the year.

However, rising crude oil prices could prompt central banks to reassess their monetary easing or delay interest rate cuts. The expected El Nino weather phenomenon and elections in some EM countries next year could also trigger fiscal easing, which would ultimately lead to higher inflation. 

Most importantly, the yield spread between EM and DM continues to narrow, which makes us more cautious given EM has lost some competitiveness against other asset classes. As a result, we have trimmed some of our overweight positions. Nevertheless, we are still constructive in the medium term given high real yields in some countries and the downward trajectory of global growth.

EM FX carry may have peaked for the year

We have been reducing our exposure to EM FX risk given the challenging economic backdrop and the resilient US dollar in light of rising US yields relative to EM. At the same time, the market is becoming more concerned about European growth, while the Chinese renminbi appears overvalued amid a lack of meaningful stimulus and sluggish growth expectations. We are more cautious in our positioning and remain nimble.  

We are currently slightly underweight credit beta and remain cautious on the credit outlook given the uncertain macroe environment. EM credit asset flows and sentiment support has been relatively weak. Cash levels remain elevated as valuations are not yet attractive enough to increase our credit beta. 

The new issue market has picked up dramatically, but the performance of new deals has been underwhelming. The only cheap part of the asset class appears to be the highly distressed sector, which remains volatile while many countries still lack access to the primary market.

IG spreads closer to historical tight levels

We continue to de-risk into strength, climb the liquidity and quality spectrum, and selectively participate in new issues. Nonetheless, hard currency emerging market debt continues to offer investors high coupon income, diversification from other parts of the fixed income market and access to some of the fastest growing economies.