This article first appeared in Livewire markets on 14 February 2024
Defying a troubling geopolitical environment and confusing macro signals, US equities delivered a record return in 2023 and Australian stocks recently hit a record high.
With inflation and interest rates appearing to have peaked, markets are pricing in rate cuts as early as the third quarter of 2024 – a sentiment that the US Federal Reserve Chairman Jerome Powell recently sought to temper in his latest speech.
What does all this mean for investors? In the first of a two-part series, we compare views from inside fixed-income asset managers PIMCO, Fidelity and Western Asset – to find out how they’re currently positioned and why.
When will interest rates start to pull back?
All three asset managers believe central banks have reached, or are very near, their interest rate peaks.
“There’s always a level of interest rate that stops people borrowing and spending and I think by the end of 2023, most parts of the developed world have reached those levels,” says PIMCO's Adam Bowe, executive vice president and portfolio manager, Australia.
“As this year progresses, most of those central banks will be in a position to start lowering interest rates. In the US, that will probably be somewhere in the middle of the year. And the RBA will be able to start lowering somewhere in the second half.”
He notes that inflation levels in the developed world are now far closer to target levels than they were 12 months ago.
“It’s still above central bank targets but not that far. As we get through the next couple of quarters, I think those central banks will have a lot more confidence in their inflation mandate,” Bowe says.
Adam Bowe, PIMCO
Heading in the right direction
Lukasz de Pourbaix, global cross-asset specialist, Fidelity International, has a similar timeline in mind: “There was a lot of anticipation late last year and at the beginning of this year that we might see a cut in March, but we think it's going to be in June.”
“Things are heading in the right direction, but there are still some pockets of potential inflationary pressures, which [the Fed and the RBA] just want to ensure are settling down. We don't get a scenario whereby they start cutting rates and then you get a reinflation type of scenario and they’re chopping and changing.”
With the market currently pricing in five cuts, de Pourbaix suggests this could increase to six or seven if we see a softening in the global economy during 2024.
“It's going to be incremental. So, probably 25 basis points to start with. Then it will be dependent on the future data that comes through, in terms of economic growth.”
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Lukasz de Pourbaix, Fidelity International
A more aggressive US Fed
Western Asset’s view also aligns with consensus, in that a March cut is unlikely and a first cut from the US Federal Reserve is expected in May or June 2024.
“Our view is that inflation will be well below Fed forecasts by the end of 2024, meaning that the Fed is likely to be required to cut more aggressively than is currently priced,” says Western Asset.
“US monetary policy is quite restrictive at current levels. In mind of the associated long and variable lags, the risk of keeping rates restrictive for too long is rising.”
In Australia, the Western Asset team expects the RBA to cut rates in the second half of 2024.
“They will start after most developed markets because inflation remains higher and because they did less tightening. Also, while unemployment remains near historical lows, it will need to rise from current levels to give the RBA comfort that wage pressures are contained.”
In light of this, how is your portfolio currently positioned?
Bowe says PIMCO's bias is to be at least at benchmark duration, “while looking at opportunities to be long duration, to have more interest rate exposure than our benchmarks.”
“We always have to look at what’s priced in. We had a big rally in bonds to finish Q4, so we’re a little closer to the benchmark rate now but we’re looking for opportunities to add duration over the coming months and quarters as we start to approach that cutting cycle.”
“But it also depends on the market, because a lot of central banks peaked at different levels and the market is pricing easing cycles of different magnitudes over coming years,” Bowe says.
“We think Australian government bonds look attractive relative to other developed markets currently, as the market has priced much fewer rate cuts."
Bowe also believes there are "good reasons" why Australia's interest rates appear to have stopped where they have.
"That’s because policy is just as tight here at 4.35% as it is at 5.5% in the US – and that’s because of the higher leverage on households’ balance sheets," he says.
"The percentage of their income that households now have to dedicate to servicing debt is already about as high as it has ever been in Australia.”
Within its corporate credit exposure, PIMCO maintains a conservative position, with very little exposure to high-yield bonds and a bias toward sectors that are more resilient to macro challenges.
“With government bond rates so elevated, you don’t have to reach down the capital structure and take a lot of credit risk to generate income. So, we’re staying in high-quality defensive, assets, further up the capital structure,” Bowe says.
In terms of specific sectors, this varies across different countries.
“In Australia, we’re trying to avoid direct exposure to household spending – that’s the vulnerable sector,” Bowe says.
“In the US, it’s the complete opposite, with household balance sheets in great shape. So, we’re really happy to take exposure to RMBS or other sectors linked to household spending – we expect the US to be a lot more resilient than Australia.”
Zooming in further, Bowe and his team like owning the debt of assets such as toll roads and regulated utilities in Australia. He also notes that Australian universities are appealing, because they issue debt and are benefiting from rising immigration.
“The reward’s not there” in high yield
Fidelity’s fixed-income team is also biased more towards developed markets, with limited exposure to areas such as emerging markets.
“From a sectorial perspective, we have a lower allocation to things such as high yield. It’s not that there aren't any opportunities there, but from a risk-return perspective, we think the reward's not there at this stage,” says de Pourbaix.
“We're keeping our powder dry, in terms of our duration allocation and cash allocation. When the time's right, we will deploy some of that and potentially look at opportunities in some of those things like emerging markets for example – but not at this stage.”
Within corporate credit, Fidelity is currently neutral on investment-grade credit: “We're not ultra-bullish or ultra-bearish. The spreads are looking relatively tight,” says de Pourbaix.
He emphasises a focus on quality, but says the team isn’t troubled by speculation that corporate debt levels are dangerously elevated.
“Our credit view isn’t based on a view that there's some kind of debt wall coming and that there's going to be more risk in terms of that part of the market.”
Despite the narrative that we're in a soft landing, de Pourbaix remains cautious that we could see more risk coming back into the market: “The potential risk of recession is still there down the track. So, we want to be relatively conservative in terms of our credit exposure.”
Balancing short- and long-duration
“In the US we have a bias at the front end around the two-year part of the curve. The front end now offers some protection, with front-end rates expected to rally in a risk-off scenario,” says Western Asset.
That said, Western Asset also holds an overweight to long-duration, “for additional protection against a more challenging and prolonged economic slowdown.”
“In Australia, we have generally held an overweight in 10-year and 20-year bonds for ballast and to opportunistically capture the volatility in markets. At times, we have looked to underweight the short end when we feel that the market is pricing cuts too early in the cycle.”
What lies ahead?
In part two, PIMCO’s Adam Bowe, Fidelity’s Lukasz de Pourbaix, and Western Asset each discuss the market signals they’re watching most closely from here. They also provide their insights on how the global economy and bond markets may look 12 months from now.
