The Elusive Landing

After circling to land late last year, the US economy has unexpectedly revved up in 2024. And in a more surprising development, growth has lately reignited globally—including in Europe, where recession had long been looming, and possibly in China, where a bounce in manufacturing may signal at least a temporary rebound.

Combine this higher-than-expected growth with record-high gold prices and rallying commodity markets, and a case could be made for a reheating global economy.

For fixed income investors, growth can cut both ways. Resilient US growth has translated into higher-than-expected inflation and employment over the past month—and thus, to higher government bond yields. By mid-April, the 10-year US Treasury yield had risen to 4.63%, up 68 basis points (bps) so far this year.¹ Outside of the United States, government bonds did not see such pronounced moves, but in most regions, the uptick in growth and investors’ desire for all-in yield created an almost voracious appetite for credit.²

What do frothy credit markets, stronger-than-expected growth, stubborn US inflation, and rising US Treasury yields add up to? At their meeting this month, Lazard’s fixed income professionals discussed the repercussions of this combination for markets around the world, as well as the overarching issue: whether this is a long landing or a surprise extension of the post-pandemic recovery.

US: Will They or Won’t They?

For US bond investors, the heart of the matter was how US economic resilience would affect inflation and thus, the Federal Reserve’s plan to cut interest rates. The Fed’s “dot-plot” forecasts released in mid-March showed a median path of three rate hikes totaling 75 bps this year.

As stronger economic data has rolled in since then, the bond market has begged to differ. Investors reacted dramatically to the above consensus increases in the US Consumer Price Index (CPI) on 10 April. Core CPI, which excludes food and energy prices, rose 0.4% over the prior month and 3.8% year over year, while headline CPI increased 0.4% and 3.5%, respectively. The 10-year Treasury yield jumped almost 20 bps on that day; market pricing also showed that many investors had reduced the number of Fed rate cuts they expect this year to two and pushed back their predictions for the first cut from June to September or even November.³

Corresponding to this overall view, the yield curve has had recent “moments” of steepening, our analysts noted, with long-term yields rising faster than short-term rates did—a move known as a bear steepener, which is consistent with higher inflation expectations.

While the bond market reacted quickly to the latest inflation report and other economic data, our US team was more circumspect. In their view, the larger disinflationary trend that began in 2022 was likely still intact—albeit with some bumps stemming from “sticky” services and housing inflation. With months of data yet to come, they continued to expect the Fed to start cutting rates this summer.

They also pointed to the Fed’s sizable balance sheet as a potential policy tool. Currently, the Fed has been shedding its balance sheet assets, or tapering, by up to $95 billion per month, a form of quantitative tightening. But the Fed’s meeting minutes for March revealed that the majority of Fed officials was in favor of slowing that pace soon.⁴

There has been little change to US portfolio allocations. Positioning for a steeper yield curve and overweighting agency mortgage-backed securities remained two of the team’s strategies for seeking above-market returns. Avoiding much of the credit market was another: Spreads were still near historical lows, and availability was low, especially in longer maturities, the team reported.

Despite tighter spreads, investment grade credit could not keep pace with the rise in Treasury yields over the first quarter and returned -0.08% based on the ICE BofA US Corporate Index. US high yield fared better with a positive return of almost 1.51% and a healthy 3.22% for lower quality securities rated CCC and below, according to the ICE BofA indices.

Emerging Markets: Distressed Does Best

Our emerging markets team witnessed a similar pattern of performance in hard currency bonds. The return on high quality emerging markets securities was negative for the first quarter at ‑1.5%, and even bonds rated BB could not make up the ground lost to rising US Treasury yields, with a return of -80 bps, based on JP Morgan Emerging Markets Bond Indices. Moving further down the credit spectrum, though, the indices showed that B bonds were up 4.5% and distressed debt returned a stunning 24%.

The positive return on higher yielding debt could be traced in part to higher growth expectations, the team explained. As US real GDP growth estimates were running higher than expected at 2.1–2.5% for the first quarter,⁵ the growth outlooks for many emerging markets sovereigns have improved, they noted, including Brazil, Chile, India, Mexico, and an array of commodity-exporting countries. Credit quality for high yield sovereigns has also been trending higher, with a ratio of 3.5 to 1 in favor of improving credit by our analysts’ estimate.

That helps explain the performance in high yield, but what was behind the impressive gain for distressed issuers?

First, several countries have been able to restructure their debt over the past six months—more quickly than in the past and with much higher recovery prices on their bonds, according to our team. Zambia, whose bonds increased from 74 cents on the dollar to 82, is the most recent example, with a restructuring of $300 million in eurobonds announced in late March.⁶ Meanwhile, IMF funding has also played a role in easing sovereign financial pressures, notably for Kenya and Egypt.⁷

For several distressed sovereigns, a turnabout in policy—both fiscal and monetary—has led to better performance and better outlooks, our analysts pointed out. Argentina, Ecuador, Nigeria, Pakistan, and Turkey have all implemented policies designed to improve their finances—several after changes in government leadership, our team pointed out.

Ironically, our emerging markets specialists were more concerned about deteriorating credit quality in the investment grade sector. Six countries, including Panama, were trending down in quality, while only three were improving, by their calculations. With spreads near record lows and Treasury yields rising, emerging markets portfolios remained significantly underweighted to investment grade bonds, the team noted.

Also of concern to our analysts was China. They were more worried about long-term issues, such as policies related to demographics and risks from the US election, than they were encouraged by recent improving economic indicators, such as purchasing managers’ indices (PMIs).

Europe: Turning the Corner

As growth ticked higher around the world, Europe was not left behind. Although the upward momentum was more pronounced in periphery countries, such as Italy and Spain,⁸ the data for the first quarter shows economies across the region have been strengthening, according to our European bond team. Even in Germany, which was hit hard by higher energy costs and teetered on the brink of recession for some time, industrial production has shown improvement, our specialists noted.

At the same time, inflation in the euro area has continued to drop—with core CPI down to 2.9% and headline inflation at 2.4% based on the latest report from Eurostat—and in the team’s view, that means the European Central Bank (ECB) is likely to proceed with rate cuts starting in June. Stubbornly high services inflation, running at 4% year over year currently, could result in a more gradual easing cycle, our experts noted.

The possibility of “contagion” from the United States was a risk: If the Fed keeps rates higher for longer, which has helped drive Treasury yields higher, that could put upward pressure on European government bond yields. Still, pricing in Europe’s markets indicated that investors generally expected three rate cuts from the ECB this year.

If interest rates fall, extending duration in bond portfolios could improve return potential, and our team found several attractive opportunities. Among the Nordic countries, Sweden was the most interesting, in our specialists’ view. With consumers hit hard by rising interest rates on mortgages and other loans, the Riksbank announced late last year that it would cut rates in the first half of this year, opening the possibility for higher bond returns there.

Outside of Europe, New Zealand was facing down recession, with rate cuts looking likely in the second half of 2024, and Canada, with a weakening labor market and lower inflation than the United States’, appeared to offer an opportunity for investors as well, according to the team.

Our global bond team, meanwhile, has maintained its overweighting to high quality credit and recently took advantage of chances to move up in yield without sacrificing credit quality and to move up in credit quality without sacrificing yield. The team has also continued to build its exposure to covered bonds, taking advantage of attractive spread dynamics in the sector.

Our global analysts were keeping a close eye on developments in Japan following the Bank of Japan’s historic rate hike last month—the first in 17 years. Inflation expectations rose to 1.42% in mid-April, low compared with the United States but the highest level for Japan since tracking of the data began in 2004, our analysts pointed out.

US Convertible Bonds: Improving Prospects

Unlike many fixed income sectors, spreads on convertible bonds were not tight—in fact, they have remained wide, in the view of our convertibles experts, which is a potentially attractive feature for investors. Even more compelling to our team was their attractive yield; convertibles in the information technology sector, for example, have offered yields near 5%—the highest in more than a decade.

Because convertible bonds are hybrid securities—corporate bonds that can be exchanged for stock in the issuing companies at a set price—they have characteristics of both asset classes. Like many other bonds, convertibles have faced the challenge of rising Treasury yields so far in 2024, and on top of that, many issuers in the convertible universe are mid-cap companies, which tend to be interest-rate sensitive, according to our convertible bond team.

After a modest positive return in the first quarter for the asset class, the team sees better prospects for convertibles, especially if the Fed begins reducing rates—and even if Treasury yields simply stabilize. Fundamentals should also support the securities, in their view: Many issuers have cut costs over the past few years, increasing earnings-per-share while still maintaining high top-line growth. Yet, convertible bond prices have yet to reflect these improvements, according to our analysts. And with US growth holding up well, the high level of consumer exposure in the asset class could prove to be an advantage, they explained. Finally, high yields globally and heavy maturity calendars have been driving new issuance higher so far in 2024.

Currencies: Volatility Ahead?

Higher-than-expected growth and a higher-for-longer policy rate in the United States have translated into a strong US dollar and range-bound trading against most G10 currencies over the past few months, according to Lazard’s currency team. But they see change on the way as the possibility of central bank rate cuts comes into sharper focus, and investors start to take into account some recent developments:

Although Fed officials have largely discussed inflation levels as the key driver of potential rate cuts this year, it has become increasingly likely to our currency experts that the Fed may deliver rate cuts in the midst of higher economic growth than it had expected.

• With growth also picking up globally, it is also increasingly likely in their view that the Fed will not be the only central bank to cut rates on the back of higher or stabilizing growth.
• Some emerging markets central banks that have intervened in the markets recently to support their currencies against the strong dollar may withdraw if the dollar weakens in response to Fed rate cuts, as our team expects.
  

What does all this mean for currency markets? In the team’s view, FX volatility is likely to increase soon.

For many investors, the return of volatility from almost record lows could create potential opportunities for higher returns. For those who have been selling FX volatility in the current low-volatility, range-bound environment—including some new entrants—the outcome could be very different, depending on how they manage those positions, our analysts noted.

Wheels Up

In the bond markets, as well as the currency markets, Lazard’s investment professionals were preparing for unusual scenarios as growth and inflation have defied expectations.

Tail risks—from recession to rate hikes—were ever-present, as our teams discussed this month, though they still assigned a low probability to a rate hike. In their view, the Fed, ECB, and many emerging markets central banks are likely to proceed with rate cuts this year, though the exact timing may depend on data yet to come.

With an economic landing not yet in their sight line, our bond teams were braced for the next leg of the journey.