At our Investment Outlook, Q4 2023 event last week, we sat down with Elizabeth Geoghegan, Head of Fixed Income Strategy, and Bernard Swords, Chief Investment Officer. From equities to fixed income, here we present our outlook through year-end.
Let’s begin by looking at the dramatic rise in interest rates and the relevance of this for bond markets.
Elizabeth: It has actually been the fastest and most aggressive rate-hike cycle in the history of the European Central Bank (ECB). So, what I mean by that is we’ve had the most amount of hikes in the shortest period of time. Just 18 months ago, the ECB policy rate was negative; today it’s at 4%. It is almost a 50-50 split in terms of how many hikes we had last year and how many we have had this year. Last year, the ECB hiked rates by 2.50%, whereas year-to-date we have had 2% of hikes. Yet, the experience of markets during this time has been very different: we had dramatic negative returns last year whereas this year has seen some marginal positive gains in markets.
How did this happen? Well, aside from the fact that we started with negative yields last year meaning that there was no buffer for any negative headwinds for bond holders. A big driver of market returns has been the journey that we’ve been on in terms of interest rate expectations. Markets are inherently forward looking. Meaning that oftentimes, it matters less what's happening now and more what's going to happen in the future. Using a simple equity example, if you have a pharma company announcing a new drug, the impact on the price will probably be bigger on the announcement than it will be when the revenue results of the sales of that drug are published. And it’s the same for bond markets.
At the start of last year, markets were unsure as to whether the ECB would be able to move out of negative territory. Even after the first hike in July, markets were still expecting that the ECB would finish the year below 1%, which is obviously significantly far away from their 2% level. In contrast to this, at the start of this year markets had moved to expect that the ECB would increase rates to 3.5%. This of course is still below the 4% level at which we are at today, but the point is it is not nearly as divergent as last year. It was this divergence which caused the most pain and volatility for markets last year. Now that market expectations have caught up with the ECB, we have seen a much more stable experience for fixed income markets. Combining this with the significantly positive yields, and the fact that we are nearing the end if not at the end of the hiking cycle, the outlook for fixed income returns is a lot more positive for the short to medium term.
Moving to equity markets, while there has been some volatility, year-to-date equity markets are generally up. Why is that?
Bernard: It’s been a good year for equity markets. If you look at the headline levels, equity markets are up about 12% in euro terms. The big driver of that has been how the global economy has performed this year.
Going back to December 2022, equity markets were down 7% and so, we had a very low starting point in 2023. That’s because there were fears of an energy crunch in the euro area, China still had COVID lockdowns, and the US economy was stalling. But as we’ve travelled through this year, we’ve gotten through a lot of those issues: Europe did not have an energy crunch; China removed its COVID restrictions earlier than people expected; and we’ve seen a very strong US consumer and capital investment has also returned in the US. So, 2023 hasn’t been as bad as many had expected which has resulted in a bounce in index levels.
That said, while world equities are up around 12% year-to-date in euro terms, if we take an equal weighted index – that is, where all companies have an equal share of the index rather than being weighted in terms of market capitalisation – it’s barely in positive territory year-to-date. When you look at the details, equity markets have not been as strong as the headline figures suggest. In fact, when you look at the details, it has been quite a turgid year for equity markets.
So, looking ahead, what are your thoughts on the outlook for equity markets? And what are the preferred sectors?
Bernard: We expect the background for equity markets to remain turgid and thus subdued returns for equity markets over the next year to year-and-a-half.
Why’s that? Well, the global economy has avoided a big problem, but the growth rates are not great anywhere. And so, economic growth that companies will be seeing next year is going to be no better than this year – probably even a little bit lower in nominal terms. Hence, we expect subdued earnings – and there’s still a risk around those earnings.
In terms of our overall strategy, we’re below benchmark weights in equity markets – and that’s probably where we’ll stay as we don’t think the potential returns for the risk you’re taking are large enough. Given the earnings outlook and the uncertainty around them, we’re focusing on sectors where earnings are relatively dependable – so, defensive sectors, such as healthcare and consumer staples.
And what’s the outlook for bond markets?
Elizabeth: The story for bond markets isn’t dissimilar to what is going on in equity markets. In the sense that, there is one performance picture at an index level, and under the bonnet there is significant divergence.
At a regional level, US assets have underperformed European assets. That’s because there’s been a more significant repricing of market expectations in the US relative to Europe. Closer to home in Europe, there’s been an outperformance of corporate bonds relative to government bonds. Corporate bonds have had a positive return year to date of 2.5-3%, whereas government bonds on an index level have had negative performance. There has also been an outperformance of short duration, short maturity bonds relative to longer duration bonds.
What’s driven the outperformance of corporate bonds? A number of factors: firstly, they have a better yield. So, in the absence of adverse events (such as a pickup in defaults or a weakening outlook for credit), that will lead to a better return outlook. This is typically reflected in your corporate credit spread which investors receive as compensation for taking on additional credit risk. This spread has been well behaved year-to-date. And that has helped performance because if that spread or additional yield were to rise, it would lead to negative price performance.
Corporate bonds also have a shorter maturity profile relative to the average government bond market – and that also helped cushion sensitivity to the interest rate rises that we’ve seen this year. That thematic feeds into what we’re seeing on the government bond side: European government bonds have had negative performance year-to-date on an index level, but underneath the bonnet, there is significant divergences. That negative performance has primarily been driven by longer maturity bonds – that is, bonds with a maturity of 10 plus years which are more sensitive to interest rate moves, have experienced negative returns. Whereas shorter duration or medium duration bonds have actually had a positive performance of in and around the region of 1%.
What does all of that mean for our strategy? Well, we have a preference on a regional basis for European assets relative to US assets – a preference which we further reiterated earlier this year, and which has been beneficial.
Within corporate bonds, we have a preference for very high-quality investment grade bonds which also have a very short duration. That helps us to isolate that additional yield premium and earn that yield premium without taking on additional interest-rate risk.
From a duration and interest rate perspective, we have a preference for short-to-medium term government bonds, which are less interest rate sensitive relative to longer duration bonds. What’s more, they have the added benefit of offering a higher yield at present. Were this to change however it would warrant a strategy review. Something which we are consistently monitoring, especially given more recent moves.
