Economic & Markets Outlook

Quarterly Investment Outlook
Quarter 4, 2023

Markets continue to be preoccupied by high interest rates. This is most evident in the way bonds remain in the limelight. The high volatility of bond yields has been a source of concern for some investors, with longer duration bond yields face upward pressure due to worsening long-term inflation expectations.

US bond markets have been a primary source of turbulence. This has boosted the appeal of US corporate bonds, with yields surpassing 6%. Though corporates may present an opportunity for institutional investors, their improved appeal has kept credit spreads over Treasuries in the middle of the usual range. This defies the traditional positive correlation between yields and spreads, which suggests that investors should be cautious because the dynamic may reverse.

For investors mainly interested in exposure to the credit risk premium, at its current level bonds capturing the premium are at best a hold. If the economy holds up, these spreads would bring reasonable excess returns over government bonds over time. However, if the economic picture deteriorates – which we view as more likely – credit downgrades will increase and spreads will widen, resulting in losses.

Equities continue to look fragile

High interest rates are also impacting the returns of equities, as weaker discounted future cashflows are putting downward pressure on equity valuations. In addition, although we have yet to see weaker economic growth in the US, there are signals that the expected downturn is only being delayed. First, the recovery in US equities over the past year has largely been concentrated in just a handful of major tech names rather than being spread across the economy. And second, US reported earnings have fallen by just over 10% since Q3 2022, with further slumps expected if economic growth further weakness during 2024. This supports our view that equity valuations are fragile and further encourages us to look elsewhere.

Regarding potential risks, many investors will be worried about the impact of the Israel-Palestine conflict. However, with a few exceptions, major markets have so far ignored the conflict because it appears to be confined to the region. This sharply contrasts to the Russia-Ukraine conflict, which quickly impacted several major Western European economies in early 2022.

The gilt situation

Though high interest rates continue to weigh on economies, there is evidence of the UK starting to adapt to a higher-for-longer scenario. The market consensus if for the Bank of England to further increase rates and this is apparent in the relative yields of UK gilt and US Treasury yields, with the former rising more than the latter.

With gilt yields rising, attention is turning to how demand from defined benefit (DB) pension funds will change, given they have traditionally been the cornerstone of the gilt market. Higher yields have been pushing schemes’ funding ratios higher, allowing more of them to de-risk and potentially consider buyout or buy-in deals. One implication is that pension fund demand for index-linked gilts could weaken at the margins.

Against this backdrop, many DB funds are looking to boost liquidity with some resorting to exit early through secondary market sales. For funds with the liquidity to do so, weaker gilt values present a chance to build up positions. While high rates are detrimental to non-listed equities, the higher yields available in private debt markets becoming more attractive.

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