The Southgate bond strategy – no subs in the second half

For any fixed income investors that follow the England football team, the plan for H2 2024 may feel somewhat familiar – no substitutions in the second half.

The first half of 2024 has been dominated by more stubborn than expected inflation in most countries mixed with a fair amount of politics-induced volatility. Most of the latter has stemmed from scheduled elections, but first the UK and then France were added to the list earlier than most would have anticipated. The global economy meanwhile has continued to exhibit outright healthy growth levels in certain countries such as the US, while in Europe and the UK the growth picture continues to improve even if absolute growth numbers aren’t breaking any records. This, along with strong albeit slightly cooler labour markets, has resulted in contained default rates and tightening credit spreads. 

Looking at performance year-to-date (YTD), government bonds have delivered poor returns. Part of this is down to the enormous rates rally in the final few weeks of 2023 that resulted in low starting yields by the beginning of 2024 – it is easy to forget that six rate cuts from the Federal Reserve were priced in as a result at that point. The other culprit is inflation, which has forced central banks to delay rate cuts and tame the positiveness of the inflation-is-over scenario that many had priced in. As of June 30, 10-year US Treasuries had delivered around -1.4% YTD, with the equivalent German, Japanese and UK government bonds all underperforming at -2.4%, -2.5% and -2.6% respectively (returns in local currency). Unsurprisingly the long end of the curve fared the worst, with the 30-year Bund for example down almost 10% YTD. The second half of the year started in a similar vein, with a marked sell-off across sovereign markets on Monday. 

In spite of the rates gloom, credit delivered decent performance in the first half. US, European and UK high yield had returned 2.6%, 3.15% and 4.5% respectively as of June 30. Looking at investment grade indices, even if it has not been a great year from a total return point of view, the outperformance versus rates has been notable. Taking BBB non-financial corporates as an example, returns have been 0.2%, 0.8% and -0.4% YTD for the USD, EUR and GBP indices respectively.

The standout markets have been financials and mezzanine ABS. The Coco index is up 4.2% YTD while BB and B CLOs have delivered close to 11% and 16%, respectively. Looking higher up in the cap stack, AAA CLOs have posted an impressive 3.5% total return. Fundamentals continue to improve in the banking and insurance sector, with a ratio of rating upgrades to downgrades of 2.88 so far this year according to data from Moody’s. In ABS, the weakness in CMBS has continued but this has been widely anticipated and has therefore not impacted the wider market. With rates staying at their cycle peaks for longer than previously expected, the floating rate nature of the asset class has been an important boost.

Looking forward to the second half, we believe the macro trends will be somewhat similar. Uncertainty as to when exactly inflation falls sustainably into the target range will continue to be the main driver for central banks. The political calendar is not looking any lighter, with the French and UK results due at the start of next week and the US election in November clearly having the potential to move markets. Donald Trump’s odds have increased following last week’s debate and the market’s running assumption is that if he gets back into office then US growth, inflation and the budget deficit might all be higher than otherwise. It’s still early days, however, and the composition of Congress will also have a say in the magnitude of the changes that might follow a Trump win.

Taking all that into account, for a diversified fixed income portfolio we think positioning in the second half shouldn’t look materially different to the first. Volatility in government bonds is likely to linger thanks to the ongoing uncertainty around inflation. This is not necessarily equivalent to negative or poor total returns, but we think credit will outperform government bonds in H2 even after its strong outperformance YTD.

Importantly, most of the difference will be down to additional carry rather than spread contraction in our opinion. While we anticipate volatility in government bond yields, we don’t expect a material shift either lower or higher in their trading range; our assumption is that 10-year US Treasuries, Bunds and gilts remain trading in a similar sort of wide range to that witnessed in the last few months. We remain attentive though as a cooler economy in the US might take us to a lower trading range, while a Trump win with a Republican Congress might have the opposite effect.