Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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Macro: It’s all about elections and keeping status quo
Steen Jakobsen
Chief Investment Officer
Summary: Markets are driven by election optimism, overshadowing growing debt and liquidity concerns. The 2024 elections loom large, but economic fundamentals and debt issues warrant cautious investment.
Elections remain an important theme in 2024
With the 2024 US election looming, the market seems fixated on this single factor, overshadowing other potential scenarios. While we acknowledged the inherent uncertainty, we anticipated the elections playing a dominant role in Q1, possibly influencing Q2 as well.
This wasn't about playing the markets, but rather recognising the narrative driving investor sentiment. Central banks, poised to cut rates at any sign of weakness, and politicians eager to spend regardless of fiscal prudence, created an environment ripe for "better-than-expected" data, fuelling election-year optimism.
An unhealthy amount of debt
The US government's $3 trillion debt issuance since 2022 yielded only $2.4 trillion in nominal GDP growth, yet sustained a perception of positive economic data. While this strategy did prevent an official recession, it did not translate into sound, long-term growth or economic expansion.
Further contributing to this perception was the significant drawdown of the Fed's Reverse Repo Facility (RRF), basically a government ATM. Think of this facility as a temporary "parking lot" for excess cash. The Fed absorbs this cash by selling securities with the promise to buy them back later. When this cash leaves the facility and re-enters the banking system, it gets multiplied through lending and leverage, essentially greasing the wheels of the economy.
The RRF peaked at $2.5 trillion in early 2023, but has since shrunk to under $500 billion. This has injected a whopping $2 trillion of fresh liquidity into the US financial system, underpinning animal spirits in stocks and causing crypto currencies to hit new highs.
Are markets acknowledging the liquidity risks?
Beneath the surface, however, a different story unfolds. The excessive money printing and circulation, intended to stimulate risk-taking, coincided with the October market low in S&P 500. The significant decrease in outstanding RRF balances and the Fed’s perceived pivot to cutting policy rates sent equities in a straight line upwards from late October 2023. At the current pace the RRF balance will be depleted by June, removing its stimulative effect.
Furthermore, global central banks are collectively reducing overall liquidity in Q2. We anticipate the consequences of accumulated debt, high real-interest rates, non-productive green sector investments, refinancing needs of small and medium banks, and the commercial real estate overhang to collectively slow economic growth in the immediate future.
The market's initial over-optimism regarding rate cuts has waned, with a growing acceptance of the Fed's projections. Other parts of the market have, however, gone the other way, predicting no cuts in 2024. We still believe rate cuts are likely, acknowledging the slow pace of change compared to market expectations. Remember, the market often struggles to process complex information effectively.
Investment allocation
Our investment strategy throughout Q1 involved a balanced allocation of 25% each to the 4 key asset classes: equities, fixed income, commodities, and cash/alternatives. This diversification has served us well, but as we transition into Q2, we are adjusting our allocation by reducing equity exposure over valuation concerns.
While we acknowledge the potential influence of the 2024 elections, maybe it’s time to follow the late American investment banker J. P. Morgan’s famous reply when he was asked how he had become the world’s richest man: “I made a fortune getting out too soon”.
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