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Short or long fixed income?

By Marion Le Morhedec
4 minute read

Central banks have continued to be active during the Northern summer, despite little macro data.

The European Central Bank (ECB) has restated its commitment to tackle inflation with two consecutive 25 basis points hikes in August and September.

Then, the Bank of England also raised rates with a 25 basis points increase in August.

And on the other end, we can see that the Fed has held rates steady until now.

Now most central banks seem to be at peak with some uncertainties on the Fed (US Federal Reserve), where we forecast another 25 basis points increase by the end of the year.

Policymakers will need some time to monitor macro data, especially when it comes to inflation before they can take further action. It looks like the trend will be in favour of higher-for-longer rates.

As a result, global rates have generally increased over the past (third) quarter. The 10-year German bund rate rose by 40 basis points to 2.78 per cent at the end of September. And similarly, the 10-year US Treasury rate rose by 65 basis points to 4.51 per cent.

The main question among market participants at the moment remains on the ECB balance sheet and the reduction of the APP (Asset Purchase Program) and PEPP (Pandemic Emergency Purchase Program) as another mechanism to keep inflation under control.

The US economy has proven to be particularly resilient during the last quarter, despite pressures resulting from high inflation and elevated interest rates in the past year, and in particular US consumer data, which would argue against the threat of an imminent recession.

US consumer spending surged during their summer, driven by excess savings as well as a strong labour market. US consumer credit conditions remain robust, despite rising credit usage.

Some tensions are starting to emerge in credit card and auto loans, but overall, credit conditions are healthy and not concerning.

In the eurozone, despite the soft data, we have been positively surprised by the fundamentals of corporates in Europe.

Revenue growth softened in 2022 but continued to be in positive territory. Similarly, EBIDTA margins remained solid, thanks to a focus on cost structure. Leverage has remained flat overall and did not deteriorate significantly. However, if we look closer across the credit rating spectrum, we notice some weakening for BBB segments, where the leverage has significantly increased.

Long or short?

In this context, let me highlight our positioning across our fixed income portfolios.

Duration: In the US, the economy was more resilient than anticipated, which pushed Treasuries to new highs. In Europe, we expect bond yields to evolve in a rather tight range.

Overall, we find valuations attractive across both markets. We are long duration with a steepening bias.

Europe peripherals: Valuation starts to be stretched in a context of slower growth and risks of fiscal tightening. We have a short bias on Italy, but with a very limited risk budget and are neutral on Spain and Portugal. And finally, on euro investment grade, while we remain constructive on the asset class, we believe that valuations are fair. We favour financials and some defensive sectors like telecoms and utilities.

Our preferred strategies

Considering the current environment, we believe a few strategies are worth highlighting for investors.

Short duration strategies: we continue to see yield curves inverted, which makes short duration strategies attractive.

Currently, we do not see the reward for holding longer maturity bonds. As we anticipate the first rate cuts in the course of next year, the downside pressure on rates is likely to be concentrated in the front end, rather than the back end of the curve, making short maturities more attractive.

Credit investment grade strategies: From a yield perspective, credit remains the asset class to focus on within the bond sector. The US and European investment grade credit markets provide a healthy yield of around 5 per cent, some levels that we have never seen over the past 10 years.

There is no doubt that companies will suffer from the new era of higher rates and prolonged inflation.

However, we believe a soft-landing scenario would prevent massive shocks in the economy.

We have already seen how resilient the economy has been and how corporates manage to navigate around 2023.

Marion Le Morhedec, head of fixed income, AXA Investment Management