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July 2024
Overall Neutral on fixed income
Reflecting our expectations for higher US rates on the risk of inflation rebounding next year, we turn Neutral on duration. As an extension, we downgrade our position on Developed Markets (DM) Investment Grade (IG) bonds to Neutral given the long duration profile of the index. We remain Neutral on Emerging Markets (EM) bonds, expressed via an Overweight on EM High Yield (HY) bonds while being Underweight EM IG bonds. Given these changes we turn overall Neutral on fixed income, as we anticipate volatility leading into the US elections.
Rates and US Treasuries
The recent weakness in macro data and the latest inflation readings are consistent with our view that the US is headed for a soft landing. Therefore, we maintain expectations for two rates cuts this year (September and December meetings) and only one in the first half of 2025.
However, we have raised our 10Y US Treasury (UST) yield forecast from 3.75% to 4.25%. The anticipated rate cuts are likely to impact the front-end more and we expect 2Y USTs to move down to 4% over the next 12 months (currently in the 4.75% area).
This reflects our expectations for a steepening of the yield curve when the Federal Reserve (Fed) pivots to rate cuts. While we maintain our preference for the front-end, we think investors should reduce the long-end exposure in favour of the belly (3-5Y).
In its mid-year update, the US Congressional Budget Office (CBO) revised its fiscal year budget deficit to US$1.9 trillion (about 7% of GDP) for 2024. The CBO now expects the budget deficit to rise a cumulative amount of US$2.8 trillion from 2025-2034 and US national debt to reach US$57 trillion, leading to debt/GDP ratio of 122% by 2034.
We think concerns about fiscal impulse and inflation expectations, a conceivably higher UST supply, along with some potentially negative ratings action on the US government debt could dampen market sentiment, driving term premiums higher on the long-end. Meanwhile, the front-end is exposed to reinvestment risk when the Fed pivots to rate cuts.
Developed markets
Reflecting an upward revision in our US rates forecast, we downgrade our position on DM IG bonds to Neutral from Overweight. Performance in IG bonds are dominated by the rates component, which contributes a substantial 80% of total yields. With spreads so tight, we see limited room for further compression. The current low spreads are reflective of the strong fundamentals, as evidenced by the upgrade trajectory – upgrades are outpacing downgrades at a record 4.8x. However, we caution that there could be scope for deterioration in credit metrics in a “higher for longer” rates environment.
Hence, we think investors should be selective and raise the defensiveness in the fixed income portfolio. We think the front-end and belly of the curve provide more buffer against yield volatility given the higher yield-to-duration cover.
Emerging markets
We maintain a Neutral position on EM; expressed via an Overweight on EM HY against an Underweight on EM IG. Spreads have massively tightened in EM HY, and we think there could be limited scope for further material tightening from here. However, the prospects of carry from EM HY keeps us Overweight on the sector.
Asia
In Asia, we continue to prefer HY over IG. However, we now see HY as a carry play in 2H2024 given the large spread compression year-to-date. As for IG, its comparatively shorter duration and lower market beta should keep spreads range bound, barring major macro and political shocks. All-in yields remain attractive from a historical perspective.
In China, two major political events will take place in July. For the Third Plenum on 15-18 July, long-term economic reforms relating to risk containment, fiscal/monetary policies and new quality productive forces are likely to be key focus areas. For the Politburo meeting at end July, specific property destocking policy action will be keenly watched.
As for Indonesia, despite committing to a 3% fiscal deficit cap, investors’ concerns over the medium-term fiscal outlook could linger until more policy clarity is given after the inauguration of the new administration in October and the new Finance Minister shortly after.
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