Part 1: The aftermath of 2023 – where to next?

Each piece breaks down one asset class, starting with fixed income today.

Fixed income

Stephen Cooper, head of Australian fixed income at First Sentier Investors

Last year saw a further material increase in yields in fixed income markets, resulting in below-average returns across the asset class. While near-term sentiment now favours a relatively soft landing, markets are priced for a material rate cut cycle in most major markets in 2024.

As a result, central banks are facing a difficult decision – do they stand firm and focus primarily on inflationary pressures that remain elevated, or do they soften their stance and moderate current policy settings as inflation moderates to maximise growth and employment outcomes?

To paraphrase someone much smarter than me, forecasting is hard, particularly when it comes to the future. The current economic climate is one which central banks have not faced for several decades and so the policy response at this stage remains unclear.

In either case, value has returned to the bond market and fixed income assets now offer at least some protection against a significant downturn in other asset classes. Correlations should return to their longer runs norms, after a period in which inflation and interest rates, rather than economic growth and risk assets, drove markets. Even if inflation proves stubborn and rates move higher from here, we are significantly likely to still see positive returns as running yields are higher and the scope for further increases is somewhat more limited.

Our base case is for inflation to prove somewhat more persistent over coming years – reflecting a reversal of globalisation, a negative impact from demographics (e.g. aging populations) and a change in corporate acceptance that prices can be adjusted – resulting in higher average interest rates relative to the past decade or more. That said, we still expect interest rates to experience meaningful cycles as economic fortunes fluctuate, and bonds can again play their part as a diversifier in portfolios, moderating volatility of risk assets.

The key risk to this view, in the short term, is that restrictive policy settings already implemented bite harder than expected, resulting in a harder economic downturn and risk asset underperformance. Credit assets would be negatively impacted in this environment, while bonds should perform strongly. Investment grade credit is relatively well buffered at this stage and should still perform well over the medium term, but higher yield assets may see significantly elevated rates of default and performance volatility.

Over the medium to longer term, the key risk is inflation proving even more stubborn than we anticipate which would result in higher rates, softer growth and a longer period of deleveraging. In this case, the recent experience of correlated poor returns across asset classes may resurface (although again, the backup in yields to date should soften the blow on fixed rate assets relative to recent years).