Off the back of a volatile 18 months in markets, fixed income looks to be in a “really good” position to deliver returns for investors, according to Kellie Wood, head of fixed income at Schroders Australia.
“We’ve been waiting a long time for this, probably about 12 years, so it’s good to see the return of fixed income as an asset class in general,” she said.
Particularly, the set-up is ripe heading into the back half of 2024, she said, given the current economic environment of moderating inflation and slowing growth.
Appearing on the latest Relative Return episode, Wood observed, “If you think about the conditions for fixed income to deliver very strong returns, it’s an environment where inflation’s moderating, growth is slowing and central banks are cutting interest rates, and that’s exactly the environment or the set-up that we’re looking at for this second half of 2024 and into 2025.
“That’s the type of environment where fixed income not only delivers very strong absolute returns, but very good relative returns versus asset classes like cash and equities.”
However, she conceded that this outlook appeared far less promising just eight months ago, despite a remarkable year for fixed income markets in 2023.
“I think it’s worthwhile considering 2023 because that was a great year for fixed income returns. It was an environment where we saw reduced risk of recession, inflation was moderating, and central banks were pivoting to policy easing, which set up that soft landing environment,” Wood said.
“We saw very strong returns across fixed income in 2023, but the start of 2024 looked a little different.
“It was a little more challenging in that the markets went back to pricing that higher for longer or reflationary environment, so an environment where, yes, inflation was still moderating globally, but growth was holding up and fixed income at the start of this year was struggling in terms of total returns.”
Examining the current opportunity set, she noted significant prospects emerging from the “huge” divergence between growth and inflation in global economies, even as markets largely continue to price in the same policy path.
The US and Europe are witnessing moderating inflation and weakening growth, she pointed out, while the “stagflationary” Australian economy is “six months behind what we’re seeing playing out in the rest of the world”.
“That’s been the main thing about this cycle that’s been so different in that we’re seeing a huge amount of divergence between growth and inflation,” Wood said.
“If you look at the US, Europe, UK, even in Canada, we’ve broadly got priced into markets the same easing cycle, which is around 100 basis points of easing over the next year. In Australia, we don’t have many cuts priced again. We’re pricing that higher-for-longer environment because inflation is so much stickier here – we haven’t actually seen that progress on inflation coming down.
“So, we’re seeing a lot of divergence within economies in terms of that growth in inflation mix, but yet the market is broadly pricing that same policy path. That means for us as bond managers, it really creates a lot of opportunity in terms of what markets we think can outperform versus underperform in this environment where central banks are starting to ease cash rates.”
Areas of opportunities
The investment executive described Australian investment grade credit, or Australian subordinated debt, as the fund manager’s “most favourite asset class at the moment”, explaining that it is offering yields at the 5–6 per cent mark with a low probability of loss.
“You compare that to what we’re expecting on Australian and US equities – which is over the next three years, an expected return of around zero and around a 50 per cent chance of loss – we certainly see the defensive asset class offering more value,” Wood said.
Additionally, she noted, as central banks start reducing cash rates to more neutral levels, this positions fixed income to deliver not only strong absolute returns but also excellent relative returns.
Other opportunities on Schroders’ radar over the next year include credit markets, particularly Australian credit, and mortgages in the US and Australia.
“I think valuations on US credit and US high yield have become very expensive, so our preference is to be owning Aussie assets, investment grade credit and high yield. We’ve also been preferring European credit markets, just given the volatility we’ve seen around the French elections, we’ve had a preference to be owning European credit over US credit,” she said.
Regarding mortgages, which have been enhancing the quality of yield in Schroders’ portfolios, she noted that yields on US agency mortgage-backed securities are between 6 per cent and 6.5 per cent, while Australian mortgage yields are just below 5 per cent to 5.5 per cent.
Wood added: “We haven’t seen any sort of defaults or real risk in terms of the housing market here, and I think if the RBA does potentially ease over the next six to 12 months, then we actually see good support from that sector.”
Additionally, in seeking inflation protection in portfolios over the last 12 to 18 months, she described tactical allocations to inflation-linked bonds and credit allocations to sectors “that actually give us that protection against inflation”.
“So, earning corporates that have their earnings linked to inflation and maybe in electricity distribution, transmission or gas pipelines, or tolls,” she said.
According to Wood, looming risks such as the US election have supported the need to build in such protections.
“We have seen great moderation in inflation in most of the developed world over the last 12 months and there is that risk, I think, just in terms of certainly election outcomes in the US, that we do start to see the inflation premium build up in markets,” she said.
“That will lead to potentially higher yields in the back end of bond market curves, but also higher inflation premium in that environment where growth could potentially stay higher for longer and inflation reaccelerates.”
