Fixed income: Pendal’s 2024 outlook for bonds, credit and cash

What lessons can fixed-income investors take from 2023 into 2024? Pendal’s head of income strategies AMY XIE PATRICK summarises the outlook with fellow PMs TIM HEXT, GEORGE BISHAY and STEVE CAMPBELL

• Pendal’s 2024 outlook for bonds, credit and cash
• Why bonds, why now? Pendal’s income and fixed interest experts explain
• Find out about Pendal fixed interest capabilities

I LOVE this time of year. Not only is there plenty of holiday cheer, there is also time to survey the landscape as we head into a new year.

Five key observations that stand out to me from 2023:

• Recession never arrived, though it was widely expected at the start of the year
• Inflation came off without a significant rise in unemployment
• Riskier assets saw healthy returns while bonds had another challenging year
• US 10-year real yields pushed past 2%
• Small and regional US banks have not solved their fundamental problems.

Interestingly in October, when the real yield on 10-year US treasuries tested 2.5%, the bond sell-off halted.

Perhaps the market was saying: “sure, growth is strong now, but the party won’t last forever”.

How we fared in 2023

Pendal’s fixed income team reassessed the situation when we saw the economic data wasn’t weakening.

We identified that, in Australia, the fixed-rate mortgage cliff was a red herring.

George Bishay, our head of credit and sustainable strategies, moved away from a more conservative stance and started to re-risk his credit portfolios.

From banks to utilities, industrials to infrastructure, George has been cherry-picking his way through the primary market since things calmed after the US banking crisis.

“As long as inflation can continue to come down, bond market volatility can be contained,” says George.

“As long as bonds are no longer aggressively selling off, I’m happy to be tactically raising my credit exposures.”

Tim Hext, Pendal’s head of government bond strategies, recognised that just because inflation had peaked, it didn’t mean the fight was over.

While keeping duration positions small during the year, volatility threw up many opportunities in the physical bond space that he was able to take advantage of.

“You can’t ignore the fact that they’ve continued to pump out fiscal stimulus in the US,” says Tim.

“Australian bond markets have been passengers in the US-led sell-off.

“However patient the RBA wants to be, CGLs (Commonwealth Government Loans) couldn’t fight the strong tide of US Treasuries.”

Steve Campbell, our head of cash strategies, has had similar views, but was able to position a little differently in his portfolios.

“The cash funds were predominantly longer than the benchmark over 2023, despite the Reserve Bank continuing to tighten monetary policy,” Steve says.

“The additional yield and the steepness of the curve helped protect the cash funds’ performance from the move higher in yields over the period.”

As Pendal’s head of income strategies, I have the privilege of all this expertise around me.

The income funds benefited from the wisdom of my peers, positioning at first defensively and then risking up on credit.

Positioning long enough in duration earlier in the year in time for the Silicon Valley Bank crisis, then pulling back in to weather the bond storm.

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Pendal’s Income and Fixed Interest funds

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In more defensive moments, Steve made sure extra cash in the income funds kept up with or beat offerings on term deposits – with the added advantage of liquidity.

I’ve enjoyed having that liquidity at my disposal this year. The income funds can take on exposures in Australian equities and emerging markets.

Although both those asset classes generated positive returns this year, there was plenty of volatility along the way.

Thanks to liquidity provided by Steve, the high yield he has offered on cash and our active asset allocation process, the income funds have been able to take advantage of this environment.

Where to from here?

Here’s a quick 2024 outlook on bonds, credit and cash from our income and fixed interest portfolio managers.

Bonds

Bonds have had three challenging years in a row – will there be a fourth? I ask Tim Hext.

That’s very unlikely, he argues.

“My framework for 2024 is for falling inflation and yields. Though as always, I’ll be flexible within the framework, since it likely won’t be a straight line down.”

That’s a good point to remember, I believe. It’s been a while since we’ve had straight-forward, unequivocal bond rallies.

“If the US Fed cuts rates as expected, markets will price in cuts here,” says Tim. “Though the RBA will likely be slow to react, since they rely on the lagging indicator of inflation to set policy.

“I’m watching the new RBA monetary policy board and how that works.

“Also, don’t forget stage-three tax cuts come in July.”

And the line I like the most from Tim: “Even if policy is on hold here for most of 2024, markets will not be standing still.”

This paints a backdrop against which our active investment process can shine.

Credit

Would rate cuts mean bad news for riskier assets like credit?

“Not necessarily,” says George Bishay.

“Like the past year, if the market can feel that inflation can be contained and the growth picture holds up, that’s basically a Goldilocks scenario and equities should do fine.”

Where Australian credit goes is largely led by where US equities have gone before, George often reminds our team.

If the Goldilocks picture can continue, George will be happy to hold on to the risk he now has. But he’s also ready to act if that isn’t the case.

“That’s why I’ve been very discerning in the type of risk I’ve been adding over the year,” George says.

“You can’t ignore the tail risks out there. As the US banking crisis showed us earlier in the year, sentiment can sour very quickly.

“I’ve kept to top-quality issuers, stayed in senior positions in capital structures and always had an eye on liquidity when I’ve been adding risk this year.”

Thanks to George’s nimble approach, I’m not worried about the income funds’ ability to pull credit risk in at the right time.

Cash

Will cash still be in vogue if a new cutting cycle starts in 2024? I ask Steve Campbell.

“Let’s not confuse the RBA with the Fed,” Steve reminds me.

“I expect fourth-quarter inflation to be lower than the RBA’s forecast. That should mean the Reserve Bank is done hiking.

“But any talk of a new RBA rate-cutting cycle is premature. Inflation is still too high and the labour market is still too tight.

“I expect the cash rate to remain unchanged over 2024, though with bouts of volatility.

“Significant global monetary policy tightening since early 2022 and related spill-overs will become more obvious in the coming year as economic growth slows further.”

Because of the uncertain environment ahead, Steve argues that “highly liquid cash strategies rather than term deposits are a better way for investors to capitalise on any bouts of volatility.”

If things go south and bonds still can’t protect you, it’s critical to have a deeply experienced cash manager by your side.

If Steve is right about bouts of volatility, our active and tactical return booster levers – which buy equities or emerging markets – should continue to get a work-out in 2024.

But if he is also right about a further slowing of economic growth, I expect tactical forays into riskier exposures in the income funds will become less frequent.

Recession odds for 2024

The consensus on US recession stands in stark contrast to this time last year.

Economies have been far more resilient than markets anticipated – and markets in turn have adjusted their expectations.

Soft-landing is now the narrative.

Worryingly, fundamentals have deteriorated as the lagged effects of monetary policy tightening play through.

There doesn’t need to be another Silicon Valley Bank-like shock to send the US economy into recession in the second half of next year.

In fact, I’d put the odds at about two-thirds.

It just takes the continuation of the same economic trends we’ve witnessed in recent months.

Slack is coming back into labour markets. Fewer people are quitting, fewer employers are saying it’s hard to find workers.

Lending standards have tightened, meaning credit growth will keep contracting and default rates will keep climbing.

Delinquency rates in consumer loans have risen for seven quarters straight (not months).

The concentrated exposure of smaller US banks to the commercial real estate sector is an unresolved tail risk.

Nothing in that list is dramatic, but the collective force is more likely than not to bring on a recession in 2024.

For much of 2023, the narrative was about too much supply and not enough demand for US government bonds.

If a recession hits next year, demand for safe-haven assets will overwhelm supply, even if the fiscal taps remain on.

Equity markets tend to peak about six months ahead of a recession.

The next few months is a chance to get your house in order.

Consider rotating back into fixed income and cash – and look for good active management.