The Macro
The US economy has dodged exogenous shocks relatively well so far, but in our view, many segments in the US economy are still out of sync. In general, the global economy has been unsynchronized and uneven over the last few years. The combination of various disruptions from the pandemic, coupled with multiple regional wars and growing geopolitical tensions, has impacted global trade flow and commodity prices, but also introduced the concept of “deglobalization” and the need to rethink how businesses operate. These factors share a common feature: they are inflationary. Inflation also had a major boost from the joint easing efforts of monetary and fiscal policy.
As we look ahead, there are many macro questions at hand. Is it too soon for markets and the Fed to claim victory over inflation? If central banks start easing in earnest, is it too late to “soft land” given the “long & variable lags” from this cycle? If easing starts, do we run the risk of rekindling inflationary pressures? Meanwhile, perhaps the resting place for rates (i.e. neutral rates) are higher than most are used to, and maybe what central banks mean when they say “higher for longer” is that rates won’t go back to zero, and the era of QE and easy money won’t return unless the economy goes into a tailspin. Lastly, can the US economy really decouple if the rest of the world is still weakening?
Within these big picture narratives are many sub-plots and intertwined factors. When combined, they guide us in our analysis on what to look out for next year. We remain open-minded, but continue to view US conditions as late cycle—and in order to re-accelerate the US economy, rates have to drop meaningfully.
The Markets
In our view, starting points for valuations matter for all US fixed income. At this juncture, it is likely that financial markets have already pulled forward the best-case scenario: the so-called “soft landing” narrative. Even if we get large rate declines, as we expect, credit spreads and risk assets are pricing perfection.
Big picture, outside of MBS and rates, most credit spread levels are near the tight end of our 2024 range forecasts. Thus, from current levels, we see limited upside in total returns from pure play credit products. Risks will inevitability surface in 2024 and the downside could be substantial if we get the more “bumpy landing”. We suggest to wait for a pullback instead of chasing.
- In rates, investors need to triangulate when interest rate cuts begin and how far the Fed will drop rates versus negative carry considerations. As discussed, we believe the Fed needs to re-steepen the curve. Thus, our favorite ideas revolve around finding the most optimal curve trades.
- In mortgages, we remain constructive on the MBS-basis. However, we are mindful of the risk that prepays pick up. MBS should outperform credit.
- In investment grade, we believe the product will lag in a rates rally, which could serve to widen spreads at times. With supply mattering once more.
- In high yield credit, it will come down to US economic health and whether liquidity will still flow into risk assets. Idiosyncratic risks will also play a role in bond selection. From a spread basis, we are cautious HY at current levels.
Please download the PDF for the full write-up with charts (and the rates forecast table on page 35)…
We thank our colleagues, Glenn Schultz, Andrew Myers, and Bill Matthews for their product area contributions to this strategy report.
