Solid returns appear set to continue

Slowly, slowly, softly, softly 

The bond rally is over for now as expectations for the path of US interest rates are once again being reset. This is mostly in response to the September US employment report being stronger than expected where 254,000 jobs were created against an expectation of 150,000, while the unemployment rate fell back to 4.1% from 4.2% in August. It goes without saying that no-one, least of all the Fed, should respond to one piece of data but the employment report did allow the market to introduce a little more realism regarding future rate cuts. Some have criticised the Fed for cutting rates by 50bp on 18 September. This is unfair and the Fed never indicated it would continue to ease by 50bp moves. The reality is that real short-term interest rates are quite high and potentially restrictive and the economy is on track for a soft landing. The moving three-month average of payroll numbers suggests a year-on-year growth rate of employment of around 1.2%. This is reasonable but it is below what has tended to be the growth rate of jobs in the US outside of recessionary periods. The soft-landing scenario remains largely unchallenged.

Buyers again?

The retreat in bond prices might draw some buying into the market. The view is that the Fed will cut two more times this year so the Fed Funds Rate will end up at 4.5%. Given the core consumer price inflation rate came in at 3.3% in September, this leaves real short rates still firmly in positive territory. It remains a supportive environment for fixed income. For this year, global aggregate bond total returns might end up at around 3.0% with the profile being a negative first quarter (Q1), a flat Q2 and then an above trend return in Q3. For next year, it seems reasonable to set expectations at a similar or slightly higher level, with more to be gained from the credit markets given where spreads remain today. 

Valuations rich in bond markets 

The macro backdrop is supportive for fixed income even if there are risks from reflationary policies should Donald Trump win the election in November. Broadly, however, there are concerns about valuation. Rates curves are priced for a soft landing so bets on the direction of rates are either going to be non-consensus or tactical responses to short-term moves. On the credit side, spreads are narrow across all ratings buckets and currencies. Credit is towards the expensive end of its relative valuation versus a swap benchmark, and this is more pronounced in the US than it is in Europe. The implication is credit’s excess return is somewhat limited (the carry) while there is asymmetric risk in terms of potential spread movements (i.e. there is more room for spreads to widen than narrow). 

But yields and income attractive 

However, from an all-in yield perspective, credit remains attractive as yields are still well above their pre-tightening levels. Interest rates are coming down, so the relative value of credit against cash is improving. Moreover, the fundamentals are solid for credit, demand is strong and, despite increased issuance this year, technical trends in the market are also positive. An example of this comes from the UK pensions sector. The trend of defined benefit pension schemes entering buyout deals with insurance companies is continuing and is expected to run at between £50bn-£60bn annually for the next few years. The insurance buyers of pension fund assets aim to maximise the spread on the assets above the swap rate so whenever credit spreads widen, they will be buyers. As with rates, there is likely to be a buy-on-weakness backdrop to demand for credit in fixed income markets, unless the fundamental backdrop changes. Any risk-off related to concerns about the geopolitical situation is likely to be followed by buying.

Fiscal concerns 

Government bonds are cheap on the metric of comparing prevailing yields to the swap curve (the difference between swap rates at differing maturities). For the long end this is particularly true. In the UK gilt market, for gilts above a 15-year maturity, the average gap between the bond yield and swap rates is around 60bp. The high over the last 10 years is 80bp. German, French and US government bonds are similarly cheap with the French spread at its highest level over that period. To me this reflects concerns about government borrowing and the sustainability of current fiscal positions. Relative to history, corporate bond risk is seen as lower than government bond risk! Of course, in a risk-off environment this could all change. Buying credit protection (credit default swaps) and an option on going longer duration would be the clear risk-off trades in fixed income.

Soft landing favours equities 

Under the central scenario equities offer better prospects for returns in 2025. Lower rates should sustain stronger trends in consumer and business spending while the structural themes of artificial intelligence and the net zero transition will underpin enterprise spend. The consensus view is that Trump would be positive for equities in the US, but Kamala Harris would only be mildly negative given her ambitions to raise corporate taxes would be thwarted by Congress.

Current earnings forecasts for stocks are strong. For the S&P 500 the consensus is for 14% growth over the next year and 25% for the Nasdaq Composite universe. A 14% growth in S&P 500 earnings, with the current multiple unchanged, would mean an index level of 6,100-6,200 could move into sight. There is also optimism around the outlook for small cap stocks with the consensus forecast for the Russell 2000 at 73% growth. Lower interest rates are helpful to smaller companies that are more reliant on bank financing and a broadening of spending in the economy. It was interesting that the correction in technology stocks at the beginning of the summer coincided with a strong rally in small caps, just as the market started to more aggressively price in Fed rate cuts. I also note that bank lending growth has started to pick up modestly after being flat for a year or more.

Earnings and politics key to the bull market continuing 

Equity returns should outpace bond returns going forward on the assumption the soft landing does not become harder. The upcoming earnings season will be useful in setting those expectations as we approach 2025. If China’s stimulus is real and effective then global growth prospects will, at the margin, improve. A pick-up in the manufacturing cycle will be to the benefit of industrial companies and could allow some expansion of multiples in stocks in the automation, transportation, and construction sectors.

The wild card, to the upside, in the global outlook, would be an end to hostilities in Ukraine and the Middle East. Imagine peace in both regions and the opportunities for rebuilding, to the benefit of the broader central and eastern European area and to the broader Levantine region. A lot must happen for that to become a reality, not least of which will be the approach of whoever is the next occupant of the White House and how the political situation in Iran unfolds. But instead of always thinking about the negatives, what about a thought-exercise of thinking about potential positives, however unlikely they may seem now.

A post-conflict scenario in Israel with changes in political structures in the region could at last usher in prosperity for societies that have been blighted by decades of conflict. The potential for renewable energy generation, smart agriculture, tourism, leveraging Israeli technology expertise and finance from the Gulf states could all be elements of an economic revival. The price of Lebanon’s international bonds rose sharply this week; the Tel Aviv stock market is at a record high, and the Beirut stock market is close to its highest level since 2007. These observations do not sit comfortably with the daily news reports from the region but markets are cold-blooded and forward looking. Peace and recovery in the Middle East would be by far the best story to emerge in 2025.

(Performance data/data sources: LSEG Workspace DataStream, Bloomberg, AXA IM, as of 10 October 2024, unless otherwise stated). Past performance should not be seen as a guide to future returns.