Rates, Inflation and the New Regime

Traditional Fixed Income has returned as a more meaningful discussion point for Institutional Investors in a post COVID, post-zero rate world as the asset class is once again providing both attractive income as well as defensive properties for portfolios. But while the higher cash and bond rates are more attractive for fixed income investors, the question remains as to whether the economy can handle this new regime of higher rates – as higher borrowing costs should in theory impact risk assets and company’s / consumers ability to spend and borrow.

For now, the consensus answer to this question from asset managers appears to be a resounding “yes”, due in part to productivity gains arising from AI, immigration (in the US), as well as most Central Bank inflation targets expected to be met.

Manager Sentiment:

One of the key highlights from the trip was the consensus view among managers that the economy is headed for a soft landing. Among managers, 77% believe that the Federal Reserve in the US will achieve this, and a further 14% forecasting a “no landing” scenario. This is a significant shift from the more pessimistic views held in 2022. Only 2 managers expect a hard landing. A contrarian view might be that the consensus is wrong, just like many were wrong in forecasting a hard landing 18-24 months ago. However, it is arguably much “easier” to forecast a benign or reasonably stable environment than it is to forecast a poor or recessionary environment, given recessions / materially negative environments are relatively rare.

Interest Rates and Inflation:

The longer term, neutral real cash rate (the theoretical real interest rate that supports the economy at full employment /maximum output while keeping inflation constant) in the US is expected to have increased, with all but one manager seeing this within the range of 0-1% or 1-2%. This is much higher than during the post GFC period. Many managers now argue that the environment of low inflation, loose monetary policy, and tight fiscal policy is “permanently” over. If the neutral real cash rate is indeed higher, this would result in both a “higher for longer” scenario, as well as a “soft landing” scenario concurrently, two market dynamics previously thought to oppose one another.

Source: JANA, Bloomberg

The average manager forecast for US 10y bond yields at the end of 2024 is 4.0%, with 91% of managers seeing the Fed achieving their inflation target of 2-3% by the end of 2024. The missing component to this equation is the “term premium” – an estimate of the compensation given for holding longer dated debt. Increased fiscal spending, continued bond market volatility and a normalisation of the curve, results in a consensus view of ~0.5% for this component of 10y bond yields. This is again, is higher than recent periods where estimates of term premium have been negative. Even those managers who previously viewed a negative term premium as acceptable due to Traditional Fixed Income’s role as a hedge to other parts of the portfolio (i.e. negative Beta and its implications on CAPM), have now conceded that they expect this to be positive going forward.

Source: JANA

Credit Spreads and Default Rates:

In terms of credit, most managers forecast default rates in line with the long-term average (3-4% range), with some predicting defaults to rise to the 4-5% level or even above. Regardless of the range of eventual defaults, the other prevailing theme was defaults being “higher for longer.” The consensus view was that even though defaults may not spike, they are likely to remain elevated for some time as the new reality of higher rates continues to affect the bottom end of the market. This theme is exacerbated by the “amend and extend” mentality of lenders, who have been more willing to provide loan amendments and extensions than in prior periods.

Source: JANA

Spreads across High Yield (HY) are seen as expensive, but not extortionate and it’s expected they could stay around current levels for a while. On a relative value basis, consensus is that European HY is less expensive than US HY. Lower expected default rates due to a higher quality market is stated as one reason.

Source: JANA

Emerging Opportunities

Though the focus of this trip was on Global Bonds and Macro, it was within Credit that the most promising new opportunities were found.

1. Enhanced Passive Fixed Income Strategies: Some large managers are offering enhanced strategies alongside their flagship Index strategies, providing new opportunities for investors. A marginal increase in fees allows for a ~15-20bp alpha target for these strategies.
2. Private Credit CLOs: The expansion of Private Credit CLOs provides a more liquid, diversified alternative/exposure to the private credit space than direct lending. The ability to tailor risk via tranche selection is an especially attractive attribute of this asset class, beyond it’s more direct counterpart. We see additional benefits of this feature for Institutional Investors that need to manage capital risk charge implications.
3. Private Credit Club Syndication Offerings: JANA have been offered to participate in seed funding for a private credit offering by a large global bank sponsor. This opportunity would offer exposure to not only PE sponsored lending, but the bank’s entire commercial loan book. This sounds interesting and is akin to what other large successful managers have done domestically.

Conclusion

The JANA Global Bond and Macro Trip 2024 offered valuable insights into the current state of the economy, bonds, macro trends, and credit markets. The consensus manager view is that the global economy is headed for a soft landing, with manager sentiment being decisively bullish. For the US, higher for longer is the consensus likely scenario for interest rates going forward. Currently, the market and consumers appear equipped to handle this regime change. Credit spreads remain tight both in the US and EU, but a benign (though marginally elevated) expected default environment, and high demand due to continued high all-in yields, may see these tight levels persist for some time.
Please contact your JANA consulting team for any questions on how best to navigate the ever-changing market landscape, or for more detail on our emerging opportunities.