Rate cuts from the Fed are likely as inflation falls.
Bond yields are higher than they’ve been in nearly 15 years, presenting investors with a variety of opportunities regarding fixed income.
The economic backdrop has also improved recently and is poised to be favourable in 2024 given falling inflation trends and subsequent likely rate cuts from the Fed according to Western Asset, a leading global fixed income manager and part of Franklin Templeton.
“What’s more, the breakdown of the traditional 60/40 (equities/bonds) portfolio that occurred over the last year or so—the historical negative correlations between stocks and bonds that help investors diversify—has largely been restored. Bonds once again can serve as a valuable hedge to equities and other risk assets.
“This is especially important as they offer compelling income in both nominal and real terms, which is well above recent equity yields (S&P dividend yield of 1.4%, as of year-end 2023). In other words, one of the most important qualities of fixed-income—the diversification benefit—appears to be functioning again.
“Finally, we believe current yields may be a reasonable indicator of what investors can earn over time,” notes the team at Western Asset.
The Western Asset portfolio managers add “Valuations have been most favourable for investors in last 15 years. With investment-grade credit currently yielding upwards of 5%, investors can beat cash rates and don’t need to reach for yield in riskier sectors any longer. In fact, today’s bond yields are also as attractive as they’ve been since the global financial crisis, according to Bloomberg. But one benefit in the aftermath of the recent rough patch is that yields and valuations have been restored—offering new opportunities for carry.
“Improving backdrop has created strong tailwinds for fixed income. The pace of global disinflation over the past six months has been remarkably swift, beyond most expectations. Inflation data in developed markets has already fallen close to the Fed’s 2% target, reflecting positive trends across major economies. We anticipate this broader disinflationary momentum will persist going forward, though likely in fits and starts as sticky components like goods prices and rents are likely to normalise at a more uneven cadence. Nevertheless, inflation moving closer to the Fed’s target increases the likelihood of interest rate cuts by the Fed in 2024 without a US recession.
“Traditional correlations are back offering diversification benefits. Market expectations for Fed rate cuts, aided by lower and more stable inflation—along with the Fed’s own admission it is likely nearing the end of its tightening cycle—has helped traditional asset class correlations normalise.
“Equities shot up in 2023, with the S&P 500 returning over 24% for the calendar year. Meanwhile, US Treasury had modestly positive returns (across the yield curve) and the Bloomberg US Aggregate Index rose 5.53%.
“In short, bonds are once again providing the ballast and the classic 60/40 investment strategy is working again. The evidence of this can be seen in the sharp decline of US Treasury yields in March 2023 (notably at the front end of the yield curve) following a “flight to quality” due to heightened concerns over US and European banking system stability.”