Back on Track?

Bond investors may finally have something to cheer about.

After three months of higher-than-expected US inflation, monthly price gains eased last month to 0.3% versus 0.4% in March, according to the latest Consumer Price Index (CPI). Overall, annual inflation came in at 3.4%.

At the same time, core CPI, which excludes food and energy prices, slipped to its lowest rate in three years at 3.6%,¹ and “shelter” inflation, which includes rent and has remained stubbornly high, slipped to its lowest annual rate in two years.²  

To bond investors, the shift in inflation opened the door wider to rate cuts from the Federal Reserve this year. As a result, the relief rally was immediate: US Treasury yields dropped across maturities, with the benchmark 10-year yield down 9 basis points (bps) to 4.36% the same day.³

To Lazard’s fixed income professionals, the easing in inflation was not surprising in light of the softer economic reports in the preceding weeks: a drop in consumer sentiment in the University of Michigan survey, weaker retail sales, a lower-than-expected increase in jobs, and a dip in the Atlanta Fed’s real GDPNow indicator.

Nevertheless, it was a significant development, in their view, especially after a difficult first quarter for bonds. At their meeting this month, our fixed income teams discussed the likely impact of the softer inflation report as well as the fallout from the past three months of higher US inflation, growth, and Treasury yields. Their conversation centered on risk assets: high yield bonds, emerging markets—and in an unusual twist—equities, with a view from Lazard’s multi-asset team.

The Big Picture: Bonds vs. Equities

Easing US inflation and the series of softer economic data over the past month gave bonds a strong boost, but rising inflation during the preceding three months had done some damage. By 25 April, the US 10-year Treasury yield had risen 82 bps to hit a high for this year of 4.7%. Equities, however, had the opposite reaction, with the S&P 500 Index gaining around 6% over the same period and about 11% through mid-May—while also setting record highs along the way.

Strong earnings were a big driver of the equity rally: Nearly 80% of S&P 500 constituents beat consensus earnings-per-share (EPS) estimates.⁴ But the rise in inflation was also a factor, in the team’s view, as many investors recognized that in the past equities have generally weathered inflation better than bonds have.

However, by early May, the team noted that the rally had driven the equity risk premium well below its long-term average. They therefore reduced the overweighting to stocks as well as the underweighting to bonds in multi-asset portfolios. In their view, enough progress had been made on bringing inflation down from its peak in 2022 that high quality bonds should act as an effective hedge against a growth slowdown and other risks.

In addition, they believed the softening in inflation should lead to a less hawkish view on interest rates overall, which could, in turn, help expand the US equity rally to small and mid-cap companies sensitive to shorter-term borrowing costs. As a result, the team has tilted their equity exposure more toward small and mid-cap stocks of late. Even though the European Central Bank is widely expected to begin reducing rates before the Fed does, the team has also maintained a preference for US over Europe and non-US exposure in general due to their more favorable outlook for US domestic growth.

Emerging Markets Debt: Breathing Room

The shift in the outlook for US rates was also a key development for emerging markets—and a very welcome one. Three months of rising US Treasury yields and extraordinary strength in the US dollar had prompted a sell-off in local currency emerging markets debt that extended across all regions, from Central and Eastern Europe to Asia and Latin America, our experts noted. Short-term yields moved almost in lockstep with US Treasury yields, they added.

Looking ahead, assuming US inflation remains contained, the greater likelihood of Fed rate cuts this year means emerging markets central banks should have more breathing room to set their policy rates based on domestic conditions without worrying as much about the impact on their investment flows and their currency values against the dollar, our emerging markets specialists pointed out. Slowing US inflation and moderating growth should also reduce the concern over “US exceptionalism”: the risk that stronger-than-expected US growth could lead to tight Fed policy—and tighter-than-necessary conditions in other regions as central banks maneuver around the Fed.

Given this better outlook, where can investors find opportunities in local currency bonds currently?

Since the Fed last raised rates 25 bps in the middle of last year, emerging markets central banks have taken different courses of action—some following the Fed higher, others holding rates, and still others starting to cut—and this dispersion has created opportunities, according to our emerging markets bond analysts. One way of identifying them lies in using each central bank’s estimation of its neutral policy rate—the level that would not stimulate or restrict the economy, also known as R*—and comparing that with its current policy rate.

For example, the Brazilian Central Bank has estimated its neutral rate at around 8.5% vs. the higher current base rate of 10.5%, suggesting room for rate cuts—and the potential for gains for bondholders. Indeed, bonds in Brazil were attractive to our team, as were those in Mexico and South Africa following the recent selloff.

Emerging Markets Currencies

From the perspective of our currency specialists, the softer US CPI report—with its possible implications for Fed policy—has the potential to trigger a long-awaited unwinding of long positions in the dollar.

That would be good news for emerging markets currencies, although they have held up relatively well against the strong dollar so far, our team noted, with the JP Morgan Emerging Local Markets Index (ELMI+) flat so far this year. Looking ahead, the currency team saw plenty of potential opportunities as well. For one, they believe the Brazilian real has depreciated to “fair value.” They also favored Mexico, Colombia, and India, and found the rupiah more attractive after a surprise 25-bp rate hike from the Bank of Indonesia in late April. Currencies with idiosyncratic stories, including Egypt and Turkey, held appeal, in their view, and the South Korean won seemed oversold amid the crossfire in Asia as the Japanese yen fell to more than 30-year lows against both the Chinese yuan and the US dollar.

In a note of caution, our experts were somewhat uneasy over the lack of volatility: Implied volatility in the currency market remained historically low even as softer US economic data rolled in over the past few weeks.

High Yield: Up against a Wall

For the high yield sector overall, the potential for Fed rate cuts in 2024 raises the possibility of lower financing costs for companies. However, for lower quality, distressed borrowers, one or two rate cuts—the expectation built into market pricing after the US inflation report—probably won’t help much, according to our US high yield team.

Within the sector overall, bond investors have greeted higher quality companies eagerly over the past few months, but they have not rolled out the welcome mat for the lower quality tier—approximately 25% of the market, by our team’s estimate.

Despite a relatively strong earnings season, with around 64% of high yield issuers in the ICE BofA US High Yield Index beating consensus forecasts, constructive earnings outlooks, and even falling bond and loan default rates this year, companies in the lowest quartile face a daunting obstacle, our team pointed out: some $110 billion–$130 billion in debt coming due over the next two to three years. The cost of refinancing that debt has risen significantly following the Fed’s 11 rate hikes over 2022 and 2023.

So far, many of these companies that are unable to refinance their coming maturities may resort to liability management exercises, which generally preserve equity value to the detriment of bond holders. It is the team's view that these actions are short-sighted, provide fleeting refinancing relief, and often do little to change an over-levered company's long-term default prospect. Investors have grown wary, our high yield specialists noted, and already, the average spread for CCC companies in the ICE BofA index has widened to about 900 bps. Our team has responded by allocating risk across rating buckets and generally avoiding stressed issuers. The team is focused on issuers with compelling risk-reward scenarios.

European High Yield

In Europe, the high yield sector showed a very similar bifurcation, according to our analysts: The higher-quality segment—generally in the BB range—enjoyed much higher demand and far tighter spreads than the lower tiers rated B and CCC. As in the United States, the main reason was the looming mountain of debt maturities.

However, by our analysts’ estimates, the maturity wall in Europe was much larger relative to the size of the market. Some 23% of outstanding corporate debt rated B and CCC in the eurozone will come due in the next two years, according to their calculations, and 47% will mature in the next three years—almost half of the outstanding debt in the segment. That compares with 11% and 24%, respectively, in the United States, they pointed out. With such heavy refinancing to come in Europe, our analysts were concerned about the impact on yields for the segment.

One exception and a bright spot in the speculative sector to our team: the Nordics. Because much debt is floating rate, Nordic companies have been forced to adjust to higher rates and higher funding costs already, our European experts noted.

Change in Mindset

As high yield investors can attest to, the slight easing in US inflation over the past month hasn’t completely changed the game. Indeed, the path for US interest rates is still far from certain; just before the CPI report, Fed Chair Jerome Powell reiterated that rates could stay high for longer than expected to keep inflation at bay.⁵

Yet, the latest US inflation report supports the case that the disinflation trend that began almost a year ago may still be in place, as our fixed income teams noted, and that has revived investors’ expectations for Fed rate cuts and the possibility of a soft landing for the US economy.