Stay invested in bonds

We continue to see value in bonds, given their relatively high yields and the potential for interest rate cuts to generate additional positive returns from capital appreciation. As the Fed, in time, lowers its monetary policy rates, we expect to see bond yields fall across the Treasury curve, but much more significantly at the front end. Longer-dated Treasury yields are likely to decline less and over a longer period of time, in part due to an abundance of supply. The government’s large refinancing needs put upward pressure on yields in late 2023, and with more coming in longer-dated bonds in the coming quarters, that pressure could return.

Should the economy weaken more or faster than we expect, the Fed could accelerate its rate cuts, causing short-dated bonds to outperform more quickly. Conversely, if inflation remains sticky near current levels, rate cuts likely will be further delayed. Indeed, in an environment where unemployment is low (at just 3.9% in the last reporting, not far from the pre-pandemic lows near 3.5%, which were themselves 20-year lows) and financial conditions have already begun to ease (e.g. bank lending standards have loosened modestly), the Fed committee has little rationale to begin cutting rates as long as inflation remains above its target. Remember, the Fed has a dual mandate to support employment and contain inflation. In today’s environment, we believe the Fed will favor lowering inflation over raising employment, in part because it was widely perceived to have been late to act when inflation surged, and thus is eager to reestablish its ability to control inflation.

In the corporate bond markets, we continue to believe investment grade bonds are attractive for long-term investment. Yields are still high relative to recent history, and aggregate credit fundamentals are largely supportive. The market is currently forecasting earnings growth of about 11% in 2024, which is better than last year’s roughly 3%. While profit margins have deteriorated a bit over the last few quarters, we’re still seeing near-record levels across the investment grade universe and are comfortable with current aggregate leverage metrics. However, one thing we are keeping an eye on is a possible pickup in mergers and acquisitions as CEOs become more optimistic about the economy. The impact of financing mergers and acquisitions through greater debt could weigh on individual company’s credit worthiness.

Ultimately, we believe the investment grade credit market is likely to produce attractive income from the bonds’ current yields. However, with the current yield spreads-over-Treasuries near historical lows (fueled by demand for yield), we think there is little room for spreads to compress further. While spreads can remain low for a long time given strong demand for yield, spreads could widen quickly given a catalyst, such as equity markets stumbling. This skew in risk, with limited room for credit spreads to tighten further and a lot of room to increase, puts a greater onus on careful sector and security selection to both generate greater potential for capital appreciation and avoid sectors or individual names that could see fundamental deterioration and thus spread widening.

Bottom line, favor short-dated Treasuries in the short-term, and high-quality investment grade corporates for their yield.

The risks: sticky inflation and weaker growth

Our positive outlook for U.S. stocks and bonds is predicated on our core assumptions being at least roughly correct: The economy won’t slip into recession, inflation will slowly decline toward the Fed target rate and interest-rate cuts will follow. As such, the primary risk to our positive outlook is that we are wrong on one or more of these expectations.

The largest risk, in our view, is that inflation stubbornly refuses to decline to the Fed’s target level, delaying interest rate cuts. The economy entered 2024 with strong momentum and continues to show signs of strength. A stronger than expected economy could keep inflation stubbornly too high for the Fed or even fuel an acceleration in inflation. The extreme scenario is a kind of stagflation—where inflation remains high, and thus interest rates remain high, slowing the economy and keeping growth stagnant. While such a scenario appears unlikely given economic momentum, the sudden shock of COVID-19 reminds us that surprises can happen. Most likely, in our view, is that inflation will fall, but the path toward the Fed’s 2% long-term average target is bumpy and prone to setbacks. A few bad months of inflation data could spook markets, leading to a correction in particularly stretched sectors and securities.

The risk of weaker-than-expected growth is more complicated insofar as modestly weaker growth could put a brake on equity and corporate bond markets (which are currently clearly optimistic as both are near their respective index highs and spread lows), but significantly weaker growth could accelerate the Fed’s planned rate cuts, eventually leading to longer-term optimism from both markets. Nevertheless, the areas we are watching closely include the outlook for the consumer sector, the lagged effect of higher interest rates, and the strength of global economic growth. 

U.S. economic growth is largely driven by consumption and thus depends on this sector remaining robust. Retail sales have been wobbly recently and some consumers have used their savings to sustain continued strong spending. More worrisome is the lower to middle income segments of the consumer sector, which is seeing credit delinquencies rising in credit cards, car loans and mortgages. While we do believe a strong jobs market and (hopefully) lower borrowing costs will support the consumer, a deterioration in employment or significantly delayed interest rate cuts could eventually take their toll.

While there has been much talk in the market—and in our own writing—about the lagged effect of higher interest rates weighing on the economy, the economy in aggregate has shown resiliency to higher rates. There are signs, however, that higher rates are taking a toll in more interest-rate sensitive areas, such as the slowdown in existing housing sales, stresses in commercial real estate and the burden of higher credit card rates on lower income consumers. It could be that a greater impact is still to come as, historically, the effect is between 12 and 36 months from the start of rate hikes, and today we are just over 24 months from the first hike. But it seems increasingly likely that the effect of higher rates has been somewhat mitigated by massive federal spending. The global pandemic provoked trillions of dollars in stimulus spending, boosting the consumer and corporate sectors, and that liquidity may have been sufficient to counter the typical suppressive effect of higher interest rates.  

Finally, the global economy is decelerating. In particular, China and Europe have underperformed expectations, with both Japan and the United Kingdom recently entering technical recessions. While the U.S. economy has been growing above expectations, strong domestic growth can only last so long without strong global growth. China and Europe are not only the second and third largest economies in the world, but both are key trading partners of the U.S. Should their outlook continue to deteriorate, it would be a headwind for the U.S. economy. 

Bottom line, keep a close eye on inflation and economic growth. Both are unlikely to cause sustained market reversals but may create short-term volatility.