Welcome to 2024, and happy new year.
This is the first in a series of short articles with investment ideas for 2024. I am not an investment advisor, so treat these ideas accordingly – they are not investment recommendations. I will be adding to / editing this article in EMC as I add to it during early January. The article will focus on five themes, which you can go to by clicking on each section below:
1. Global equities relative value
The indices tracked by EMC
The table below summarises the following metrics for the six indices tracked by EMC:
FY returns for 2022 and 2023,
The current dividend yield,
The market capitalisation of each market (for size/liquidity) and
The P/E ratio (for valuation).
My views for this year with respect to each of these markets are below.
U.S. (S&P 500)
The S&P 500 has the highest P/E ratio and the lowest dividend yield of the six indices EMC tracks although US stocks have arguably earned their heady valuations. The US economy remains the strongest and most diversified in the world by a considerable margin. The U.S. also has the brightest outlook economically going into 2024, although one cannot ignore the potential effects of what will likely be a contentious 2024 election. There is also some risk that the monetary policy lag might inflict more damage on the US economy in 2024 than most investors expect, although analysts also almost unanimously expected a recession in 2023 which never came to pass. It might be time to slightly lighten U.S. exposure or to shift the composition of your U.S. stock portfolio to a more defensive blend.
UK (FTSE 100)
The FTSE 100 is a “ho-hum” market, bucking the trend of the other global equity market indices tracked by EMC both as far as losses in 2022 (+0.9%) and gains in 2023 (+3.8%). In both years, the FTSE 100 more or less slid sideways, although it is fairly priced and offers the best dividend yield of the developed market indices that EMC tracks. The London Stock Exchange is a small and increasingly “niche” stock market, and the components of the FTSE 100 are skewed towards banks, oil companies and commodity companies (collectively around 45% of the index). The FTSE 100 feels mainly like a defensive play. Investors should not expect much unless they want to bet that energy and commodities companies might make a run this year, the latter a real possibility should the US Dollar continue its gradual slide. The downside scenario would be tied to the UK economy sliding into a recession or a protracted period of stagflation, making worse an already challenging economic situation.
Europe (STOXX600)
The STOXX 600 had a good run (+6.4% in 4Q23) to end the year, but its full-year return (12.7%) still lagged the U.S. and Japanese stock markets by a considerable margin. Earnings of European companies are likely to be adversely affected by the current economic stagnation in the common currency zone. This is likely to be the major issue affecting stock prices in 2024 rather than multiple compression, as European stocks do not appear to be over-valued. The common currency bloc is very relevant in the global economy, so I consider it worthwhile to be invested there albeit am neutral as far as allocation going into the new year.
Japan (Nikkei 225)
The Nikkei 225 (+28.2% YtD) is probably at or near an inflection point following a strong run in 2023. Of the indices tracked by EMC, the Nikkei 225 was the best performing index of the year (+28.2% FY 2023), outperforming the S&P 500. The outlook might not support this continued strong appreciation in 2024, so it might be time to take some money off the table. The thesis is that tighter monetary policy would likely lead to a stronger Yen and higher interest rates, both of which would likely be drags on Japanese corporate earnings.
China (Shanghai Index)
Back-to-back years of negative returns make Chinese stocks a standout for all the wrong reasons. However, I believe that China will sort itself out economically, a topic I discuss in a bit more detail in a separate section below,. For this reason, I am a supporter of a slightly higher weighting towards China in 2024.
Emerging Markets (MSCI EM Index)
The MSCI EM Index is heavily skewed towards China, as the largest economy with the most representation (28.4% of the index) amongst the 24 countries in the index. In fact, four Asian countries – China, India, Taiwan and Sought Korea – make up 70%+ of the index. Clearly, negative returns in China have been a drag on the performance of the overall index, which was down sharply in 2022 but managed to post a decent gain of 7.0% in 2023. The case for solid performance of EM stocks in 2024 would be grounded in some combination of a weaker US Dollar and lower oil prices (for importing companies like most Asian countries). Otherwise, the MSCI EM index is mid-table as far as valuations and yield. Emerging markets stocks bring a different risk profile in which stocks can occasionally be manipulated by non-market forces, i.e. governments, and there is a degree of opaqueness that bothers many investors, including this one.
The case for adding exposure to China
Investors had high hopes for China at the beginning of 2023, only to see the country’s economy and its stock market flounder after starting well. The stocks on the Shanghai Stock Exchange appear to be dirt cheap now, trading at 10.68x trailing earnings according to the Exchange’s website . Apparently, the Shanghai Exchange excludes some of the better-known Chinese global names like Alibaba and Tencent Holdings, which are instead listed on the Hong Kong Exchange and often have dual-listings in the US via ADRs or similar instruments. After two disappointing years – and in spite of ongoing issues like a struggling Chinese property sector – it might make sense to have exposure (or more exposure) to stocks in the world’s second largest economy. If you want a mostly domestic Chinese play, think about an ETF backed by stocks on a domestic-oriented exchange like the Shanghai Exchange. Having said this, I again caution investors that the Chinese government is more than capable of muddying the waters, as it has done in the past. This can occur when the government takes aim at certain entrepreneurs / founders / shareholders or companies that run afoul of the government. Sadly, this is what makes investing in China less obvious than it otherwise might be. Taking or adding to exposure in China is a contrarian view, since many investors reduced their exposure in 2023, a trend that might continue into 2024.
Summary: global equities relative value
My conclusion as far as global indices is to have less exposure to Japan and more exposure to China. I also suggest slightly reducing (or becoming more defensive) on US stocks given their valuation levels and the low likelihood of US stocks repeating their strong 2023 gains. I am neutral on UK stocks, and slightly negative on European and emerging markets stocks. With respect to emerging markets stocks, I have no direct exposure aside from China because there are too many dynamics at play involving government intervention / manipulation. Lastly, I acknowledge that “more China” is a contrarian view that appears out-of-synch with the views of many institutional investors, at least based on what I have been reading lately.
2. US equities including "Mag 7", Russell 2000 and S&P 500 sectors
US equities rocketed ahead in 2023 after a 2022 to forget, with the star index performer being the NASDAQ, which also happened to be the worst performer in 2022. All four of the US indices I track had stellar returns in the fourth quarter, including the Russell 2000, which has been a perineal laggard. The table below presents return, dividend yield and valuation data for the for the S&P 500, the DJIA, the NASDAQ Composite, the NASDAQ 100 (not historically tracked by EMC) and the Russell 2000.
P/E ratios can vary depending on which earnings line is used, so keep this in mind when comparing these figures across different indices. I did not look into this extensively aside from the S&P 500, for which I have used earnings before extraordinary items[1].
It is difficult to draw definitive conclusions about valuations without also drilling into earnings expectations (i.e. forward earnings). It appears that analysts are expecting S&P 500 earnings to grow in the neighbourhood of 8% to 12% in the coming four quarters, a nice clip should this range be achieved. This level of earnings growth, along with expectations of five to six Fed interest rate cuts during 2024, appears fully priced in. Let me provide some perspective on the current valuation of the benchmark S&P 500 index since there is a fair amount of discussion suggesting that US stocks are currently over-bought.
The P/E ratio of the S&P 500 averaged 19.8x from 2010 to 2020, which was the period between the end of the GFC and the pandemic. This period was characterised by artificially low interest rates thanks to accommodative monetary policies of the Federal Reserve, including three rounds of quantitative easing. The interest rate environment during that period contrasts sharply to the current environment which is characterised by significantly higher yields across the curve.
The P/E ratio for the S&P 500 leading up to some notable market downturns was: 19x+ pre-GFC (S&P 500 peaked Sept 2007); 28x pre-dot.com bubble (S&P 500 peaked July 2000); and 21.4x pre-“Black Monday” crash in October 1987. Here is a long-term graph of the S&P 500 ratio from macrotrends.com, which I like because it shades the recession periods during which the ratio skyrockets because of earnings declines rather than multiple expansion. Focus on the P/E ratio just prior to an economic / market downturn, and you can see how elevated the ratio looks currently.
Any way you slice it, it is difficult to make a case that US stocks are not fully valued.
The “Magnificent 7”
Views on the so-called “Mag 7” can cut both ways. These tech giants (AAPL, AMZN, MSFT, GOOG, META, TSLA and NVDA) are large, global, dominant companies, perhaps justifying their lofty valuations. However, given their extraordinary gains in 2023, it is hard to imagine that prices of these stocks can continue to march higher for a second consecutive year. The stocks are far from cheap and appear to be fully priced based on common albeit rudimentary ratios. The table below shows the 2023 performance along with various year-end valuation metrics for the Mag 7 companies, along with similar metrics for several well-known ETFs and the S&P 500.
Sentiment around these stocks drive the market-weighted indices like the S&P 500, too. Even if you do not own any of these stocks directly, the Mag 7 account for 28.3% and 39.1% of the S&P 500 and NASDAQ 100, respectively. If you own an index fund representing either the S&P 500 (e.g. SPY) or the NASDAQ 100 (e.g. QQQ), you are essentially heavily exposed to the Mag 7 already. This being said, I think you should be invested in a core of Mag 7 names, because – although expensive – they are global giants with defensive positions and deep moats. If you are not already directly invested, I would pick the names you really believe in and “leg into” them over time, meaning make several purchases over time to achieve a reasonable average-cost. There is certainly risk that one or more of these companies could lose their lustre which would be reflected in multiple compression even if earnings are sustained.
The Russell 2000
After trailing behind gains in other US indices for what seems like years, the Russell 2000 has had an extraordinary and long overdue run in the fourth quarter, chalking up a gain of 13.6%. Investors might conclude that the index is now fully-priced on a trailing P/E basis of 27.1x, and a forward P/E of 22.7x. The run in the Russell 2000 has a lot to do with yields falling because these mid-cap stocks generally rely more on leverage than larger companies (so lower yields decrease their interest cost). The current P/E multiple is not silly, and there is probably room to run, particularly if yields continue to decrease slowly. However, there is a counter-argument that a slowing US economy in 2024 could adversely affect sales and earnings of these more vulnerable mid-cap companies, leading to a more severe counter-effect to the downside.
Risk of slower US economic growth on US sectors
Since I expected the US economy to slow like most analysts in 2023 (which it did not), I had been tilting my US stock portfolio during the year towards more reasonably valued companies in defensive sectors like healthcare/pharma, consumer non-discretionary and utilities. The 2023 recession is the one that never came, although I do believe the US economy will almost certainly slow in 2024. The table below illustrates earnings and revenue growth for S&P 500 companies in 2023 (actual four quarters rolling through 3Q23, left side of table) and projected 2024 (4Q2023 through 3Q2024, right side of table). The source is “S&P 500 Earnings Scorecard” from Refinitiv LSEG I/B/E/S).
There are two things I noticed from studying this table.
Expected earnings and revenue growth by sector for 2024 (right side of table) paint an encouraging picture as far as US economic growth, suggesting that some sectors considered more cyclical – like industrials and materials – might also experience robust earnings growth in the quarters ahead. This is contingent on an ongoing resilient US economy, which seems to be the baseline expectation.
There is a much narrower dispersion of expected earnings and revenue growth across the sectors projected for 2024, compared to actual earnings and revenue growth across sectors in 2023. This sounds only rosy to me.
Conclusion: US equities / "Mag 7" / Russell 2000 / S&P 500 sectors
As I mentioned in the section on international equities, U.S. stocks have arguably earned their lofty valuations, but this is unlikely to go on indefinitely. A pullback is not unrealistic, and in fact could provide the impetus for earnings to “catch-up” fuelling another step forward. However, my expectations are that 2024 will prove much more challenging, regardless of what the Fed does, because I cannot imagine the extraordinary broad-based gains of 2023 continuing through 2024. I think the Mag 7 are richly valued and are poised to come off their highs if sentiment shifts, but these are also excellent stocks to have in your core holdings and to add during pull backs. The Russell 2000 has also finally delivered solid gains, but the index is extremely sensitive to interest rates and economic sentiment, so either the Fed disappointing as far as (number of) rate cuts or the economy slowing faster or more than expected could derail its recent gains. At these levels for the S&P 500, it is not a bad time to take some money off the table or to hedge (index puts, or covered calls-to-fund-puts strategy).
[1] Focusing on the S&P 500 since this is the most-watched US stock index, it should be noted that – perhaps rather surprisingly – it is hard to get a consistent trailing P/E ratio for this well-followed index across different data sources. For example regarding the reporting of P/E ratios for the S&P 500, GuruFocus reports 26.33x, the Wall Street Journal reports 21.87x, and Mutlpl reports 26.16x. The differences are most likely related to which earnings line is used, i.e. earnings, fully-diluted earnings, or earnings before extraordinary line items. I have chosen in the table to use the latter (4Q22 to 3Q23 EPS of $185.52) for the S&P 500, resulting in a TTM P/E ratio of 25.7. For properly evaluating historical valuation trends, it makes sense of course to use the same data source over the period.
3. US Treasuries
US Treasuries were volatile last year, with yields increasing during the first 9.5 months of the year, then falling from mid-October onwards. Had you only seen yields at the beginning and the end of the year, you might have concluded that the bond market was relatively stable, which is about as far from the truth as can be. Rather remarkably, the the 10-year US Treasury yield started the year at 3.88%, increased to its highest level of 4.98% in mid-October, and then finished the year back at the same place it started (3.88%). The knock-on effect of changes in UST yields throughout the year proved very influential on appetite for risk assets, especially US stocks. Also, investors were heavily penalised for taking on duration until the remarkable run in the last quarter. Even so, being able to park money in short-dated risk-free US Treasuries at yields over 5% for much of the year was a benefit compared to the decade following the GFC, when short-term yields were largely anchored close to 0%.
This direction of travel of UST yields in 2023 was very dependent on economic data, especially monthly inflation and employment reports, and on expectations regarding changes in the benchmark Federal Funds rate set at each FOMC meeting. US Treasuries can be evaluated by looking at two separate maturity segments of the yield curve:
2-year and shorter-maturities, for which yields are heavily influenced by the actual or expected level of the Federal Funds rate, and
Longer-than-2-year maturities, for which yields are more influenced by a combination of the economic outlook, long-term inflationary expectations, and other demand-supply dynamics.
US Treasuries with maturities less than 2-years (short-dated)
The graph below from FRED illustrates the level of the Federal Funds rate compared to the yield on the 2-year US Treasury since 2000. The graph clearly illustrates the strong correlation between the Fed Funds rate and the yield on the 2-year US Treasury.
The Federal Reserve raised the Federal Funds rate for the first time in March 2022, increased the benchmark overnight bank rate for the last time (hopefully) in July 2023, and then started to signal a potential pivot (i.e. a suggestion that the Federal Funds rate would be reduced) following the October FOMC meeting. As you can see in the graph, the 2-year Treasury yield largely tracked the Fed’s expected moves post-pandemic, anticipating (through higher yields) the first rate increase in March 2022 and then jumping on board with a potential pivot (through lower yields) starting in the autumn of 2023.
US Treasuries with maturities greater than 2-years (intermediate and long-term maturities)
Investors in intermediate and long-dated US Treasuries also had their eyes on signals coming from the Federal Reserve during the year as to when its period of steady rate increases would end, keeping in mind that the Fed’s monetary policy decisions are a function of inflation, a key driver of long-term interest rates. Once the Fed pause began to feel permanent, investors started to anticipate decreases in the Federal Funds rate, with expectations as to the number of rate decreases in 2024 growing as we barrelled towards the end of 2023. Of course, rate reductions remain pure conjecture at this point, but expectations have driven investors to pile into duration, pushing down yields. The graph below illustrates the movement of yields on 10-year and 30-year US Treasuries since the beginning of 2022, showing the steady march higher for yields during 2022 and most of 2023, followed by the sharp drop in yields in the fourth quarter.
The narrative has changed
The only issue with the sudden and rather sharp decrease in intermediate and long term yields is that some of the supply-demand dynamics that were keeping yields high for most of 2023 have not gone away, even though disinflation has taken centre stage. Growing anticipation of easier monetary policy has now become the clear driver even though many of the other concerns which were “front-page news” just several months ago remain. Are these legitimate, and could they upend the recent rally stopping the one-way decline of UST yields in their tracks? Let’s look at a few of the issues that have weighed heavily in the past year on the UST market.
Foreign holders of USTs are significant and are reducing their holdings: The first part of this statement is clearly true, although the second part is not. According to the US Treasury Department, the amount of US Treasury debt held by foreigners was $7.57 trillion at the end of October 2023, or 28.5% of USTs held by third-parties. The absolute amount of UST debt held by foreign investors has actually increased $432 billion over the last year, although the two largest holders of US Treasuries – Japan ($1.1 trillion) and China ($770 billion) – have reduced their holdings.
Japan has been gradually decreasing its holdings of US Treasuries, most likely to fund its ongoing efforts focused on yield curve control in the JGB market and to support the Yen. Japan has reduced its holdings of US Treasuries by $202 billion since October 2022, from $1.3 trillion to $1.1 trillion.
China and perhaps other countries that do not consider themselves allies of the US or the West more broadly are trying to reduce their dependency on the US Dollar and US Treasuries to lessen the leverage that the US currently possesses on the geopolitical stage by “weaponizing” the greenback (via sanctions). China has reduced its holdings of US Treasuries by $264 billion since October 2022, or by nearly 25%.
Funding US deficits: US debt is growing rapidly, now approaching $27 trillion held by third-
parties (i.e. non intra-governmental debt, which if it were included would increase total debt to $34 trillion). The graph to the right shows the increase in US debt held by third parties in the last 10 years, which is rather frightening. US debt is growing rapidly due to higher and higher annual deficits, which reached a record $1.7 trillion in FY2023. Although there are a variety of factors contributing to higher deficits, one key contributor is the rising cost of servicing US debt, which now comprises 14% of the annual federal budget. Debt servicing costs have increased due to a combination of higher total debt and higher interest rates.
Dysfunctional US Congress: The combination of the ongoing Congressional impasse over the 2023-24 budget, and the last-minute reprieve to effectively abolish the debt ceiling until 2025 (signed into law by President Biden in June 2023) have done the US no favours on the international stage, exhibiting first-hand the very dysfunctional nature of the US government. There is no evidence that both sides of the aisle are willing to work together as the country remains increasingly polarised, making it susceptible to further Congressional dysfunctionality that might affect the integrity – or at least the reputation – of the US Treasury bond market.
US Treasury auctions: US Treasuries are sold to primary dealers (mainly US banks) through periodic auctions. These auctions occur weekly for UST bills (less than one year maturity), monthly for two to seven year notes, and quarterly for 10-year notes, 20-year bonds and 30-year bonds. Most watched of course are US Treasuries with 10- and 30-years. The average life of US debt as of May 2023 was 75 months, and UST bills (less than one year maturity) represented circa 18% of outstanding US Treasury debt, down from 25% three years ago. According to SIFMA, gross new issuance of US Treasury securities was $7 trillion to $10 trillion per annum prior to 2020, but has increased sharply since then, with 2023 issuance estimated to have totalled over $22 trillion. The tone of auctions as they occur has been a focal point for investors since the middle part of 2023, and these will continue to effect sentiment in the UST market.
Downgrades: Fitch downgraded the US to AA+ from AAA in August, whilst the last remaining rating agency with the coveted AAA rating on the US – Moody’s – put the country on negative watch in early November 2023.
Hedge fund activity in US Treasuries: Hedge funds have become much more active in the US Treasury bond market as far as seeking (and successfully) exploiting arbitrage opportunities involving small differences between prices of Treasury bond futures and cash prices. This has raised concerns about effects of the functioning of the Treasury bond market should hedge funds be caught wrong-footed and suffer severe losses, since this would be coordinated and systemic risk.
Ongoing Quantitative Tightening by the Federal Reserve: Keep in mind that the Federal Reserve is reducing its balance sheet by letting $60 billion / month of US Treasuries mature without being refinanced ($720 billion/annum).
These concerns all existed several months ago, and nothing has changed. However, investors have now subordinated these concerns to (slightly) faster-than-expected disinflation and growing expectations that the Fed will soon start to lower the Federal Funds rate. The question is whether or not these concerns might resurface at some point.
What can an investor in US Treasuries expect in 2024?
As far as the policy-sensitive short-end of the UST curve, investors should expect to continue to see yields track actual and expected changes in the Federal Funds rate during 2024. The Summary of Economic Projections of the Federal Reserve released on December 13th suggests that the consensus
view from FOMC members is that the Federal Funds rate will be reduced three to four times in 2024.
At the time I am penning this, the CME FedWatch Tool shows that investors are expecting six (rather than three or four) 25bps rate reductions in the Fed Funds rate in 2024, with the overnight bank rate at the end of the year expected to be 3.75% to 4.00%. Investors in risk assets are jumping on board with the “more cuts” scenario, even if US economic data does not yet suggest that this will be the case. Whether there are three or six rate reductions does not matter very much for investors that use less-than-one year US Treasuries as a risk-free place to park cash. Yields for US Treasury bills with maturities out to nine months are still yielding north of 5%, which looks attractive for cash set aside to be used in the near-term.
The less policy-sensitive end of the UST yield curve had an amazing run in the fourth quarter of 2023. As you can see in the table below, total returns of USTs in two maturity buckets represented by indices – 7-10 years and 20+ years – for 2022 was horrible, for the first three quarters of 2023 was not good either, but for the fourth quarter of 2024 was very good indeed.
The yield progression since peak rates around mid-October has been amazing, as yields across the curve have headed south quickly. The question then becomes “are the expected Fed Fund rate decreases already factored in, or does the intermediate and long-end of the curve have further to run?” I find it hard to believe that we will see another 100bps decline in yields across the five- to 30-year maturity spectrum in 2024.
Conclusion
Inflation should continue to fall, and the Federal Reserve will likely eventually begin to ease rates during 2024. However, inflation is not yet at the Fed’s 2% target, and the supply-demand dynamics highlighted above are still very present. I suspect that yields at the intermediate and longer end of the curve might prove slightly stickier going forward for the reasons I have highlighted in this article. However, yields might gap down again should the US economy slow more than expected and / or inflation fall faster than expected. Investors might wish to play duration, but they cannot expect similar gains going forward as in the fourth quarter of last year. Street firms are expecting the following for 2024, a diverse range for the 10-year US Treasury ranging from a 100bps decline to a 50bps increase.
Personally, I avoid intermediate and long-term US Treasuries altogether. However, the policy-sensitive short-end of the curve remains attractive, at least relative to yields that were available post-GFC.
Another play that might make sense is a yield curve steepener, which is a bet that the yields at the more policy-sensitive short-end of the yield curve will fall more than yields at the longer end. This might involve buying the 2-year UST and selling (shorting) the 10-year UST on the basis that the negative yield curve inversion (neg 35bps at year-end) will become less negative during 2024. In early July, the inversion was over 100bps, and the curve flattened significantly since then making this trade very profitable already. You can play this with leverage through ETFs, with either Amundi/Lyxor and Ossiam, noting that this is not a trade that I have done before even if – at times – it looks so obvious.
4. Corporate credit
The corporate bond market is a large and very important asset class that is often overlooked by retail investors. However, institutional investors are very dependent on the corporate bond market. Pension funds and insurance companies in particular are large and influential buyers of corporate bonds because the nature of their liabilities requires that they are matched-funded with assets, like bonds, that have fixed contractual returns. These institutions – some of the largest in the world – also have the professional staff with the requisite credit skills needed to properly evaluate and price credit assets. There are other types of professional investors that also focus on corporate credit assets, including asset managers, family offices and hedge funds. Some of these are specialist firms, focusing on specific and more narrow subsets of the credit market like leveraged loans, high yield bonds, and stressed / distressed credit assets.
Attributes
I wrote about the corporate bond market in February 2022 in an article on EMC “Corporate bonds: why you should care about this market”. That is a good primer on the overall corporate bond market, and you will be happy to know that I do not intend to regurgitate that information a second time. However, there are some nuggets you need to be aware of as you are reading this outlook for corporate credit for 2024.
Nearly all publicly-traded bonds are rated by Fitch, Moody’s and / or Standard & Poor’s. Investment grade rated bonds range from AAA/Aaa/AAA to BBB-/Baa3/BBB-, while non-investment grade bonds (aka “high yield bonds”) and leveraged loans are rated BB+/Ba1/BB+ and below. Bonds rated investment grade are obviously safer, with high yield bonds and leveraged loans becoming progressively riskier as you move down the credit spectrum.
Almost all bonds have fixed-rate contractual coupons and pay interest semi-annually. A more recent but popular form of credit asset is leveraged loans (available to retail investors via ETFs), which have a coupon that is variable at a fixed credit spread over the bank rate, normally SOFR.
Bonds have a fixed maturity date (although there are exceptions like perpetual bonds), with most ranging from three to 10 years, although some very high grade corporates have issued bonds as long as 40 years.
In addition to their contractual interest payments, bonds have other important contractual terms like affirmative and negative covenants, which have to be met by issuers.
There are several themes you need to keep in mind as you think about corporate bonds in 2024.
The pricing of corporate bonds and leveraged loans depends on the issuer’s industry/sector, the specific credit attributes of the issuer, and certain attributes of the bond itself (e.g. maturity, seniority, public credit ratings, etc). Public credit ratings are an indicator of quality for investors. The dichotomy between investment grade and high yield is extremely important for institutional investors which are often governed by specific limitations in their portfolio (e.g. the maximum percentage of non-investment grade bonds they can own, if any). The public credit ratings of a bond affect its pricing (i.e. the credit spread), as well as its volatility of price movements and liquidity in the secondary market, which can vary sharply between investment grade bonds and high yield bonds, especially at the lower end of the rating scale.
Generally, the lower the credit rating the higher the credit spread. Higher credit spreads generally translates to there being more risk, but higher credit spreads also mean that the headline yield has more capacity to “absorb” changes in underlying US Treasury yields as they move up and down. The way to think about this is that:
The lower the credit rating, the more sensitive the bond will be to idiosyncratic risk of the issuer (vis-à-vis movements in underlying USTs).
The higher the rating, the more sensitive the bond will be to changes in underlying US Treasury yields.
Evaluating Investment grade credits is generally less credit-intensive unless the bond being evaluated is migrating one way or the other, or there are company-specific risks. High yield bonds have attributes other than just the corporate credit in isolation which are important in determining the fair price of such bonds, including things like call provisions, negative covenants and location of the bond in the capital structure.
Economic cycles generally lead to lower revenue growth and margin compression, both credit-negatives. In general, the lower a bond’s credit rating, the more perverse the potential negative effect an economic downturn will be on the issuer, and hence, the bond. This is a key factor to keep in mind as we look forward to the rest of this year.
How have corporate bonds performed historically?
The table below will give you an idea of credit spreads and total returns for investment grade and high yield corporate bonds over the last five years. For high yield, I have included the data for both USD-denominated and EUR-denominated high yield bonds. The top table shows yields (i.e. effectively the interest received) and credit spreads which are added to the underlying US Treasury yield to get to the bond yield.
You might be able to surmise from the bottom table (total returns) that when US Treasury yields are falling (as in 2020, during the period following the onset of the pandemic when the Fed slashed rates), investment grade bonds tend to perform better because of their lower credit spreads and higher dependency on movements in UST yields. The contrary can be seen particularly in 2022 and 2023, when investment grade bonds suffered relatively more as the Fed was raising rates and UST yields were moving higher. (This is ignoring some of the other stimulus measures the Fed had in place post-pandemic to support liquidity in the overall US corporate bond market.)
Risks unique (mostly) to high yield bonds
There are specific risks that an investor should be aware of when investing in high yield bonds that are unique to this riskier rating category.
Credit-related: The lower the credit rating, the less the operating headroom a company has to respond to an unexpected deterioration in operating earnings. Operating earnings can be adversely affected by an economic slowdown or a full-blown recession, which often reduces a companies’ top-line demand and / or creates price (i.e. margin) pressure.
Refinancing risk: Most corporate bonds are bullet maturities, meaning the bond is due in its entirety at maturity. Very few are paid off, but rather are refinanced with a new bond issue. This raises the issue of the capital markets being closed when a company needs to refinance a maturing bond, which is more likely for non-investment grade rated companies. Difficulties can arise if there are challenging market conditions and “risk off” sentiment just when a company is facing maturing debt that needs to be refinanced. For this reason, maturity walls are monitored carefully by investors and rating agencies.
Call provisions: Investment grade bonds are usually non-call for life. However, high yield bonds normally have call provisions which allow the issuer the option to refinance the debt earlier than the maturity date. This option comes at a cost to the investor, and it needs to be considered when looking at target returns over a defined period of time.
Attributes and risks specific to leveraged loan ETFs
Leveraged loan ETFs also have unique features because of the nature of their underlying assets.
Portfolio composition: Most loan ETFs are comprised of large and (theoretically) liquid leveraged loans, which is ordinarily the senior secured debt of leveraged buyouts. However, there are other types of loan assets that can make up a loan ETF portfolio, including tranches of CDOs/CLOs (although when these are present, I would guess they are in relatively small sizes).
“Top of the capital structure”: An important attribute of leveraged loans, especially when comparing them to high yield bonds, is that they almost always are the most senior debt in the capital structure, ensuring them the top priority in the unfortunate event of a bankruptcy or corporate restructuring. If a company is highly leveraged and experiences cash flow problems leading to a default, leveraged loans will not avoid a default, just like other creditors. However, in a bankruptcy or restructuring scenario, leveraged loans are senior, secured debt, so have a first priority claim over assets and are senior to any senior unsecured or subordinated debt, including unsecured high yield bonds. This makes loans a safer bet than high yield bonds.
Floating-rate coupon: Leveraged loans are almost always floating-rate, fixed at a contractual spread over the bank borrowing rate, normally SOFR. This means the yield increases when SOFR is rising, and it decreases when SOFR is decreasing. With the Federal Reserve expected to begin lowering the Federal Funds rate this year, the yields on leveraged loans – which have been increasing since early 2022 when the Fed began its rate hiking cycle – will begin to fall.
How do you invest in corporate bonds?
I much prefer corporate bond ETFs (investment grade or high yield) and leveraged loan ETFs over individual corporate bonds. Even though I have the skills to evaluate credit, it can be extremely time-consuming, and – in theory – you should hold a relatively meaningful number of individual bonds (e.g. 10+) to achieve adequate diversification.
There are plenty of high quality ETF sponsors and asset managers that are active in the UK and the US which offer all sorts of corporate bond ETFs. I am sure this is true in other countries, too, although I am not familiar with the specifics. The table below should give you a flavour of some of the most popular corporate bond / loan ETFs that are available in the US, all involving well-known sponsors and available from US brokers.
If you are interested in digging deeper in some of these ETFs, type the ETF symbol in the table
followed by “ETF” into your browser, and you should be able to find the factsheet.
One relatively new form of investment grade bond ETFs target specific bond maturities, a list of which you can find here. I like these because they can be better used to match-fund your own needs, and importantly, they have finite lives and return to par at their maturity date (assuming there are no defaults). To contrast, “rolling ETFs” like those in the table above (and nearly all bond / loan ETFs) maintain a constant portfolio size indefinitely and include bonds with diverse maturities, making the ETF dependent over time on changes in underlying UST yields.
Outlook for corporate credit assets
Investment grade corporate bonds are the safest category of corporate bonds. Companies rated investment grade will face less risk of severe credit deterioration should there be an economic downturn. Commensurately with their risk, investment grade corporate bonds offer less-compelling current returns (compared to high yield bonds), but still offer a nice pick-up – depending on the rating – over US Treasury yields. These bonds also tend to be most sensitive to changes in US Treasury yields, meaning as US Treasury yields decline, their price will increase (ceteris paribus).
High yield bonds are currently offering mouth-watering yields, very attractive in the current environment and significantly above investment grade rated bonds. Similar to investment grade rated bonds, high yield bonds will also benefit from lower underlying US Treasury yields, but they will also be much more vulnerable in the event of an economic downturn. This can express itself in credit spreads that can widen sharply, more than US Treasury yields might decline.
ETFs comprised of leveraged loans offer better protection in an economic downturn because of their priority status in the capital structure. However, these companies remain vulnerable to a worse-than-expected economic downturn because of their highly leveraged capital structure. Their asset recovery vis-à-vis high yield bonds should be better in a bankruptcy, but that does not avoid potentially messy default scenarios. Loan ETFs will experience declining yields once the Fed starts to lower the Federal Funds rate (since the yield is a spread over the bank rate), although I doubt that the Fed Funds rate will fall below 3% - 3.5% until at least 2026, if then.
Conclusion
As intermediate and long-term yields decline in the US Treasury market, corporate bonds are a good alternative for investors that might want some contractual returns via fixed income in their portfolios. If you believe an economic downturn is on the cards, then you should probably focus on investment grade rated bonds. Leveraged loans are arguably a safer alternative vis-à-vis high yield bonds in a downturn because of their security and priority in the capital structure, but they will have lower returns (commensurate with the risk), and also face lower headline returns if the Federal Reserve starts to lower the Fed Funds rate.
5. Currencies / gold / oil
Foreign exchange is not my area of relative strength. It’s important that I start by disclosing this so readers can keep this in mind as they read my commentary below, and value it accordingly. With that health warning out of the way, I will give my views in this article regarding movements in 2024 in the most important currency pairings and the rationale for each. I also suspect most of my views (with the exception of the Yen strengthening) are contrarian, which might mean I am barking up the wrong tree. The ability (or lack thereof) of Wall Street analysts and strategists to predict markets gives me cover, since they are mostly wrong, too. I also will stick my neck out and give my views on gold and oil, albeit very briefly.
Currencies/FX
What moves currencies
Let’s start by looking at what moves currencies. Three things come to mind, all of which are in a sense inter-related:
The relative level of interest rates and expected “direction of travel” of rates in each country,
The expected growth rate / overall outlook for the economies of each country, and
The outlook for inflation in each country.
I suppose there is also a fourth factor, which is more of a macro long-term factor: how relevant / important is the currency on the global stage as far as trade, meaning is it used frequently as a medium of exchange for international trade? Clearly, the first currency that comes to mind in this respect is the US Dollar.
Let’s look quickly at the reasons that currency pairs fluctuate.
Level of interest rates
Higher interest rates – or expectations of higher interest rates – tend to attract buyers of a currency, causing it to appreciate. Lower interest rates – or expectations of lower interest rates – tend to cause investors to sell the currency, causing it to weaken. Low interest rates equate also to low borrowing costs, and this tends to draw in investors that borrow in the low-rate currency to reinvest in assets in countries with higher interest rates, the classic definition of a carry trade.
Japan has been the mother of all carry trade currencies since the Bank of Japan diverged from its G7 peers and maintained its ultra-dovish monetary policy whilst its peers started to raise their policy rates in late 2021. The Bank of Japan has not budged, still holding its overnight bank rate below nil (-0.1%) and exercising yield curve control to keep the 10y yield from rising above 1%. Since early 2021, the Yen has weakened gradually and steadily, at times knocking on the door of ¥150/US$1.00 (during the second half of 2023), very weak on a historical basis since the Yen has normally traded in the ¥100-¥110 area against the USD.
The expected growth rate / outlook for the economy
Naturally investors prefer to invest in countries that have more diverse economies with better growth prospects. This draws investors into the currencies of relatively stronger economies, although again, this also depends on the “direction of travel.” Currently, the US economy is the strongest among G7 countries, although speculation is that the US economy might slow as we work through the year. The UK and Eurozone are both teetering near nil growth, and the next two or three quarters might prove difficult in both areas. 3Q23 growth in Japan was negative YoY, fuelling speculation that the Bank of Japan might be in no rush to normalise its monetary policy in order to bring it more in line with its peers.
The outlook for inflation
In a sense, this relates to monetary policy actions since central banks “control” price growth through policy interest rates. When inflation escalates above the central bank’s target, the normal response is for these central banks to tighten monetary policy to bring inflation down. This approach is generally respected because inflation is just another way of eroding a currencies’ value. Monetary policy becomes more of a focal point when central banks follow what might be deemed to be errant policies, easing too soon or tightening too late in a cycle, for example. Perhaps the worst offense – often a fatal mistake – of a central bank is being too loose with the money supply by printing money to effectively service federal debt owed to domestic and international investors. It does not take long for this strategy to undermine the credibility of the country and its central bank, as well as its bond market and its currency.
Reserve currency status
This is a special status most often mentioned in the context of the U.S. Dollar, which is without question the top global reserve currency. Most sources I reviewed show that the US Dollar is involved in 45% of so of all international trade transactions, with Euro, Sterling and Yen accounting for 32%, 6.5% and 3%, respectively (data May 2023 from Goldman Sachs report). The US Dollar also remains the dominant currency in terms of countries’ foreign exchange reserves, accounting for on average 58%; the Euro is now around 20%. A currency that is used as a reserve currency has some downside protection that other (non-reserve) currencies lack.
As an aside, most global commodities are priced in U.S. Dollars, a reflection of the greenback’s unique status. The EUR has also gained prominence, but aside from the EUR, GBP, JPY, and CHF – and in spite of many countries wishing for increased use of the Chinese Renminbi – there are only a handful of currencies that have the stability and trust of governments and businesses to be used to conduct international trade.
My pairings and rational
Before I provide the level and rationale for my currency pairing views, the table below provides a quick look at the economic and monetary metrics of the US, the Eurozone, the UK and Japan.
I expect the following to occur during 2024:
The Bank of Japan will reverse course sometime in 2024 and start to gradually tighten monetary policy, albeit slowly but enough to provide appreciation momentum to the Yen, which is bumping around historical lows not seen since the late 1980s.
The Fed, the ECB and the Bank of England will all start to lower their policy rates, with current bets suggesting that the Fed will go first (as soon as March) and provide the most cuts, followed by the ECB and then BoE. Because of the economic weakness in the Eurozone and UK, and the fact that inflation seems to be falling faster in both areas than in the US, I think the order of policy rate decreases will be different: ECB first, BoE second and the Fed third.
These assumptions underlay my policy rate expectations for 2024, which are as follows:
USD: weaken against Yen, stable to slightly strengthen against EUR and GBP; flattish against the DXY (US Dollar index)
JPY (Yen): strengthen against almost all G7 currencies, including the USD, the EUR and GBP
EUR: weaken against Yen and USD; strengthen against GBP
GBP: weaken against USD and EUR; strengthen against the Yen
Keep in mind that FX movements have plenty of collateral knock-on effects into other global markets. For a country, a strong or weak currency can have different effects depending on whether the country is a net importer or net exporter. FX movements also can affect the performance of a countries’ internationally-focused companies. For example, FX movements can change the cost of component parts and supplies that are imported and can affect the competitiveness of finished goods manufactured domestically and sold abroad. In general:
A country with a weakening currency might see its internationally focused companies experience growth in global sales (exports) since its products will become more competitive (i.e. cheaper) on the global stage.
A country with a strengthening currency might see its companies experience a deterioration in top-line sales because these companies’ international competitiveness will lessen.
From the perspective of countries:
A weak currency generally helps countries that are net exporters like China.
A strong currency generally helps countries that are net importers like the US.
Although it often goes unsaid because governments are proud of a strong currency, a currency that is weak or weakening often effectively acts as a fiscal stimulus for a country’s domestic-based companies that are active on the global stage, although the effect on balance of trade and balance of payments is more complex. The closing message here is that as segregated as FX markets may seem, currency movements have plenty of knock-on effects into other markets at the end of the day.
Gold
Gold rose back above $2,000/oz in mid-November and has remained mostly between $2,000/oz and $2,100/oz since then. Global conflicts like Ukraine-Russia and Israel-Hamas have perhaps underlined the strength, but neither conflict has led to a wholesale flight-to-quality (and a sharply higher price) as one might expect. I think that gold will remain in the $2,000/oz up to $2,200/oz context, with support coming from ongoing geopolitical conflict and lower interest rates, which seem to be on the cards.
Oil
I remain an oil bull, not so much because I see tremendous upside, but because I think there is a floor that will be maintained even if we see a deeper-than-expected “surprise” global recession. Having said this, I think OPEC+ talks a lot but its influence as a cartel on the global stage is clearly waning. There are ongoing disruptions in global supply caused by restrictions on Russian oil (and gas), but these largely seem to have been digested and are factored in to current pricing of around $72/bbl for WTI crude (US) and $78/bbl for Brent crude (international). We might drift lower, but I would expect oil prices to remain in / around the high $70s/bbl or low $80s/bbl by the end of the year. For what it is worth, I am not in any way dismissing the validity of phasing out fossil fuels for clean energy. Rather, I believe the time frame for the transition to alternative energy will be longer than we would ideally like, and certainly longer that we are being led to believe.
Comments