Jonathan Gregory
Head of UK Fixed Income

Having rallied in the final two months of the year, global bonds managed to avoid the fate of three consecutive years of negative returns. Jonathan Gregory considers where they are headed from here.

London 1899: Guglielmo Marconi is struggling to win official backing, and money, for his fledgling radio-wave wireless messaging technology. Despite his obvious technical brilliance, barely into his 20s he is hampered in winning over sceptics by his extreme youth. Recognising that no amount of technical know-how can overcome prejudice against his age he has a marketing master-stroke and enlists Lord Kelvin, then Britain’s most famous living and revered scientist, as consulting-engineer and advocate. There is just one problem – Kelvin himself isn’t impressed with Marconi’s wireless messaging, declaring early on, “wireless is all very well, but I’d rather send a message by a boy and a pony”.

Such is the nature of prediction of an unknowable future that history is replete with such examples; this just happens to be one of my favorites, not least because Lord Kelvin was one of the brightest scientific stars of history. Trying to make the right call about tomorrow’s world? It’s just hard; even if you have already reshaped physics.

But perhaps we shouldn’t be too harsh in our judgement anyway. Consider the facts on the ground that Kelvin has to interpret; Marconi’s approach used a device known as a ‘spark-gap transmitter’ which literally generated an electric spark across a gap in a circuit to generate radio waves. The farther the radio waves must travel then the bigger the open spark (and hence the higher the voltage) needed to be. Transmitting signals over distance was not for the faint-hearted. Electric-shocks, burns, temporary deafness (from the man-made thunder) and even electrocution were occupational hazards for operators.

So when it came to the attempt to generate enough power to send the first 2,000 mile transatlantic wireless message things got really interesting; about 22,000 volts of electricity were required to power a giant spark (no small feat in itself in 1901). The equipment needed occupied a few small buildings and flashes of electricity could be seen for miles around. The transmitting station was known as the “thunder factory” because the noise was so deafening for anyone in proximity. And all this was just to generate the letter ‘S’ in Morse Code. If most couldn’t see the potential for wireless radio, frankly, who could blame them?

Please forgive my detour into the remote history of wireless technology; I admit, even in the stretched metaphors of Bond Bites, it has little bearing on fixed income today. I recount it now only because, throughout most of 2023, I found myself thinking a lot about Lord Kelvin and the difficulty of translating today’s facts into likely future outcomes for the world.

Early last year I supposed that fixed income investors would prosper in 2023. It seemed a fairly safe base-case at the time; the two prior years had already handed developed market bond investors consecutive years of losses (a highly unusual occurrence, and three-in-a-row had never happened), headline inflation had been falling since mid-2022 almost everywhere and the Federal Reserve (Fed) was likely most of the way through the most aggressive monetary tightening cycle in living memory.

To imagine that most of this was ‘in the bond price’ seemed as non-controversial as, well, the telegram-boy arriving on a pony circa 1890. Long duration positions that would benefit from higher bond prices as inflation fell further were our strategy choice for much of 2023.And then reality passed judgement on that forecast; for most of the year, although inflation had continued to moderate everywhere, and in the eurozone growth slowed to zero, central banks seemed in no mood to shift from their hawkish stance and continued to tighten policy. So as late as November 1, the cumulative 2023 year-to-date return of the Bloomberg Global Aggregate Index was -1.07%. Long duration positions were punished and a third year of consecutive losses suddenly became the base case.

And yet the stage was set for one of the most remarkable bond market rallies in history, at least outside of some broad systemic crisis. The same Bloomberg Global Aggregate Index returned almost 7% in the final eight weeks of the year to leave overall annual index returns above 5% and long duration positions in healthy profit. In fact, the fourth quarter of 2023 was the best calendar quarter for global bond returns in over 20 years. Sometimes you arrive at the destination you expected, just not on the journey you planned.

The drivers for such a stunning turnaround were multi-faceted, but most obviously linked to the Fed’s December meeting where Jay Powell signalled the end of the Fed’s multi-year campaign to tighten policy, and also raised the prospect for more rate cuts in 2024. This wasn’t the only driver though; inflation and the US labour market data had been more encouraging (for bond bulls) since October. And, while the Fed may be growing in confidence that the US can achieve a soft landing, elsewhere in the world the omens are not so good; the eurozone, China and UK have all experienced  some combination of weakening inflation, low growth and poor forward-looking indicators in the latter half of the year. These factors are generally supportive for bonds.

So, at face value, we start 2024 with the outlook for bonds seemingly set even better than 2023.

There is just one problem – what is in the price now?

Alongside the Fed’s rather dovish pronouncements in December, the European Central Bank (ECB) and the Bank of England also kept rates on hold and are probably at the peak in this cycle (although neither was quite as explicit as the Fed in saying so). But pricing might be getting ahead of itself. At the time of writing, market pricing implies the Fed and the ECB will have cut rates by about 1% by next summer (the Bank of England a little less at 50 basis points) and the Fed by another 0.5% by the end of the year. This is much more optimistic than the Fed’s own staff positions which imply about 0.75% of rate cuts in the year. And across the US, UK and eurozone, 10-year yields are 1% or more lower than the peaks seen late last year.

So markets have already moved a lot, both in terms of expectations for next year and current yields today. In our global strategies, and in response to recent bond strength, we have trimmed our long duration positions. The sheer pace of the rally late last year is unlikely to be maintained in the early weeks of the New Year and there is no question that the US economy is still performing better than expected.

That said, we like bond yields overall; across US and European government bonds in total, our global strategies are still long, just less so than in late 2023. The Global Aggregate Index currently yields 3.7% – almost exactly the same as this point last year, but now with the prospect for a smoother path for returns. Recent measures of inflation have fallen back to touching distance of central bank targets and therefore, as things stand, the prospect for interest rate cuts seems a magnitude higher than rate hikes; even if not as much as priced.

This seems most obvious in the eurozone, which might already be in a recession and, in any case, where consensus growth expectations are just 0.5% for 2024. If this is right, then the ECB will be under pressure to cut sooner and by more than the Fed.

As ever, there are plenty of risks around the central case, the most obvious relating to geopolitical tensions that could easily spill into another energy price shock or more supply-chain interruptions. While these would be bad news for inflation (probably sending prices higher), the central bank reaction function is somewhat ambiguous given the much higher starting point of policy rates today and weakening growth.

On a more positive note, perhaps it is true that today’s new technology such as generative artificial intelligence (AI) really can transform growth and productivity worldwide over the next few years. If this supported higher trend growth rates, higher productivity and structurally lower prices then we will certainly be entering a new golden age for investing. If that is your base case then almost everything will be a bargain today. But if, like me, you study the facts but just find it impossible to process the competing claims for AI, how much impact it will have and by when, well, at least we are in excellent historical company.

There is no such thing as the future – just many possible futures. Flexibility and adaptability will have to be our watchwords.

S-01/24 NAMT-475

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