Rolling down the mountain

Cheaper money  

Households and companies are going to benefit from lower borrowing costs. Markets are unrelentingly pricing in large rate cuts over the next year. Last week I wrote how this bullish sentiment was reflected in bond markets’ recent strong performance and this should continue further. Lower borrowing costs will help corporate cashflow and come as a relief to households that need to refinance their mortgage or other debt. The narrative is that we are in a modest, late-cycle slowdown, which necessitates monetary easing globally. If a recession is avoided, it is good news for investors. Indeed, if central banks lower rates as expected, the chances of a recession will diminish. Returns remain on a solid path in both bond and equity markets.

Borrow now 

Look at the US corporate bond market, as an example of lower rate implications. A year ago, the cost of new debt, represented by the prevailing yield, stood 200 basis points (bp) higher than the cost of legacy debt, represented by the average coupon. Companies would have faced a large step-up in the cost of funds if they were to refinance debt in September 2023. Today, that gap has tightened to less than 50bp. For euro-based investment grade companies, the gap has narrowed from 250bp to 90bp, and for sterling borrowers, from 220bp to 85bp. Little wonder new bond issuance activity has been so strong recently. Companies are taking advantage of much lower borrowing costs in advance of either the rates market backing up (because it might have gone too far, too soon), or credit spreads themselves widening if economic data continues to weaken. The (now) additional marginal cost of borrowing relative to the back book needs to be seen against an ongoing strong corporate earnings backdrop. There is no need for interest coverage to decline. This is positive for credit investors.

Don’t fight them 

Against this bullish bond market backdrop, this week the team at AXA IM met with several sell-side economists and strategists as part of our regular assessment of markets. The general view was that growth is slowing, and central banks are reacting accordingly. There was no meaningful disagreement with the market pricing of terminal interest rates, even if not all agree on the precise timing indicated by current market levels. The pricing of UK rate cuts looks a little anomalous compared to the US and Europe, reflecting the reluctance of the Bank of England to admit an easier stance is coming. But it is seen as just a matter of time before the UK curve moves lower as well. There was little in the conversations that shook our positive view on bonds. On Thursday, the European Central Bank confirmed market expectations by cutting its key policy rate by another 25bp and suggested there was more to come into 2025.

Searching for neutral 

As part of discussions about major economies’ cyclical position and where the line between a soft landing and a recession is, the concept of the neutral interest rate came up. A few months ago, the market was focused on inflation being a more persistent problem. There was a case for thinking the neutral interest rate i.e. the short-term interest rate if the economy is at full strength and inflation is stable (or r-star - a concept that only exists in the parallel universe of economic theory), had risen relative to the period before the pandemic and inflation shocks. A higher neutral rate would mean that nominal policy rates could not be reduced as much as in previous cycles. 

At times there were those who argued rates would need to go even higher because a higher neutral rate (which cannot be observed) meant that policy was not as tight as central banks thought. Now, there is more sympathy with the view that the neutral rate might not have risen that much. As such, current pricing of terminal interest rates is reasonable. If the real neutral rate in the US is 1% and the inflation rate is 2%, then a 3% Fed Funds Rate represents a neutral nominal rate – not easy money. Two oft-cited estimates of the real neutral rate, published by the New York Federal Reserve, suggest it lies somewhere between 0.75% and 1.25%. Thus, a risk scenario in fixed income is the fear of recession grows and the expectation that rates below neutral will be needed and nominal policy rates might fall as low as 2% or below in the US.

Risks to rates 

Key risks to the bullish pricing in bond markets could come from disappointment that inflation might not fall further, or the impact of a Donald Trump US election win, or a broadening of concerns about fiscal policy in developed economies. We will see with the inflation data but the numbers do seem to be coming down. On the election, Kamala Harris did well in the debate last week. Polls indicate a close outcome now but that could change in the weeks ahead. I will come back to the Trump policy agenda but the working assumption of bond investors is that Trump would mean higher inflation. Of course, fixed income analysts and economists worry about budget deficits and increased government supply and the impact of excessive government spending on inflation. Some even suggest the cheapening of US Treasuries at the long end of the curve, relative to swaps (a measure that traders use to assess relative value for bonds), indicates some desire for more risk premium in long-term government bonds given the US fiscal outlook. At the same time, a 10-year Treasury bond auction this week went extremely well. Poor as the fiscal outlook is, it is too distant to worry the current bond bull market.

China 

In terms of the global picture, China is seen as the weak spot. This has global implications. Weak growth stems from the ongoing slump in the property sector which has reduced investment, depressed consumer spending and led to an increased savings rate, which poses financial threats through the systemic existence of non-performing property developer debt and household mortgage loans. China is pushing export growth as the key engine of growth but because of various restrictions on Chinese exports, this can lead to price cutting in some markets (steel, for example). Globally, China is exporting deflation. Its lack of demand is a problem for exporters (Germany, for example). Without more policy action to stimulate domestic demand through boosting household income and dealing with the bad debt situation, the risk is of a debt-deflation spiral, exacerbated by poor demographics. For many years from the early 1990s, buying Japanese equity never turned out to be a great idea. That looks like being the case in China.

Donald redux? 

This brings me back to Trump. If he wins, his administration will try to impose draconian tariffs on imports – mostly on China but also on the rest of the world. This risks retaliation with tariffs being imposed on US goods by other countries. The impact of such a trade war is hard to model but is not going to be good for trade volumes, and therefore, for global growth. Inflation would go up because of tariffs and price hikes as domestic producers use the protection of high tariffs on imports to expand profit margins. Currency devaluations could be used to offset the impact of tariffs but we know that is a zero-sum game. And that would also be inflationary. 

Domestically, however, Trump would push for lower interest rates (he is a real estate man, as he has consistently reminded the world). He would extend the 2016 tax cuts and may seek further ways of reducing taxes. This suggests a difficult period for the Federal Reserve to steer a clear path for interest rates and may mean an increased risk premium in long-term yields, even if short rates need to be reduced because of the impact on growth of lower trade. Hopefully, sense will prevail, and the worst policy outcomes are low probability risks. But it is worth considering when thinking about the medium term. 

Bullish for now 

This is for consideration after the election. For now, I remain positive on markets. Rates are coming down. That is reducing the attractiveness of government bonds but they remain more valuable than prior to the start of the tightening cycle. Credit markets looks stable, with strong issuance and demand. We are going to see cash deposit interest rates fall below yields on high-grade corporate bonds in the coming months - for the first time since late 2023. This should sustain flows into corporate bond funds. Today, the gap between the yield on US high yield bonds to the Fed Funds Rate is 175bp – that is going to widen and as it does it should attract money into an asset class that offers a better risk-reward than equities.

Drama faded 

With all the focus on the rate moves, equities have taken a back seat recently. Yet it is hard to be overly bearish. Profits are healthy and earnings growth expectations have been rising. After recent wobbles, the S&P 500 is close to record highs again. Lower rates are good for stocks. I am confident that the 60:40 approach will continue to be rewarding into 2025.

Defend and attack 

The last time I mentioned football, I really regretted it. For me, watching Manchester United lose to Liverpool generates different levels of disappointment and frustration. The season re-sets again this weekend after the ridiculous international break and I hope United have worked on some of their weaknesses (like defending and attacking). The performance of the team is more challenging to predict than the daily price action of Bitcoin, and being a bond investor is much less stressful than being a Red Devils fan. Hopefully, it will not be too long before all the new players click, and we move up the Premier League table. At this point, however, I think the Fed Funds Rate at 2% and Bitcoin being worth $100,000 is more likely than the league trophy coming back to Old Trafford. 

(Performance data/data sources: LSEG Workspace DataStream, Bloomberg, AXA IM, as of 12 September 2024, unless otherwise stated). Past performance should not be seen as a guide to future returns.