By Octo AM

As the month of August draws to a close and investors adjust their allocations for the last part of the year, in this issue of our weekly bond review we’d like to take a quick look back at the summer, not because there were any major events on the markets – apart from that famous “Japanese” day on August 5, which has already been widely commented on – but because we believe that the past few weeks have indeed marked a change in economic, political, monetary and therefore financial conditions that it will be useful to take into account when managing a bond portfolio.

Let’s start with a chart of bond category performance to date, to note the main characteristic of the bond market in 2024: volatility has again come from rates, not credit, and the most credit-intensive categories have largely outperformed their sovereign or high-grade counterparts. However, a signal was suggested to us on August 5, which supposedly came from the unwinding of positions by Japanese investors, and triggered a strong bout of volatility on European high yield, even though the latter hold little or none of it:

• The high correlation of global assets
• A wait-and-see attitude on the part of investors in this segment

(Sources: Bloomberg, Octo AM)

We also note the strong performance of the sovereigns category, linked to a return to favour of market expectations of significant rate cuts by central banks in the months ahead. Between May and August, the US 10-year yield fell from 4.5% to 3.8%, while the German Bund fell from 2.7% to 2.3%, with a sharp acceleration in July.

(Sources: Bloomberg, Octo AM)

The ECB’s first rate cut at the end of the first half of the year, followed by much more accommodative rhetoric on both sides of the Atlantic, have fuelled this trend, about which we will again warn, as it already anticipates a large proportion of possible actions.
One point that has not yet changed is the inversion of the curves between very short rates (below 3 years) and long rates, with the latter anticipating six rate cuts in the USA and Eurozone by the end of 2025, bringing key rates to around 2% on both sides of the Atlantic in 9 months’ time… That’s a lot… And it’s only a short step from there to considering that we’re all the way there, as we were at the end of 2023…

(Sources: Bloomberg, Octo AM)

To conclude this overview of bonds, nothing could be more telling than a graph of credit curves, which will enable our readers to see what return (or cost of borrowing) they can expect, depending on the quality and investment (or borrowing) horizon.

Generally speaking, bond yields have fallen slightly over the past few weeks, but remain sufficiently attractive to 1/remunerate assets, 2/absorb shocks, and 3/remain a significant part of an allocation compared to yields on other asset classes.

(Sources: Bloomberg, Octo AM)

With these figures in mind, it remains to conclude that, while the graphs seem to have changed little since the beginning of the summer, or to have shown few major modifications, the situation has indeed changed, and in almost every respect:

• On the macro-economic front, as the FED has again asserted in recent days, the risk has shifted from excessive inflation to a lack of economic dynamism, with employment, consumption, international trade and confidence all showing significant declines, pointing to a slowdown or even the beginnings of a mild recession. Also noteworthy are the frequent and far-reaching downward revisions to numerous indicators, particularly unemployment, all of which point to a difficulty in forecasting, linked among other things to the change in the economic regime.
• On the monetary front, as a consequence of the first, the world’s two main monetary authorities, the FED and the ECB, have moved in the space of a few weeks from a posture of patience and a discourse more focused on inflation risks to an active posture – the ECB has already cut rates and the FED will probably do so in September – and a discourse now more focused on the risks of slowdown, or even recession.
• On the political and geopolitical front, the subject has evolved less, but has rather been a source of increased uncertainty and potential volatility than the other way round: the withdrawal of Mr. Biden, resulting in greater uncertainty in the American polls; strong uncertainty in Europe, particularly in France, but also in Germany; and a significant change in the war in Ukraine, with incursions into Russia from the Ukraine.
• At the microeconomic level, too, while the prudence and forecasting skills of many managers had enabled companies to hold up for a few months, earnings and outlooks ended up, if not giving way, at least buckling under the blows of the forces at play: the still-ongoing effect of past inflation, slowing consumer spending, rising protectionist barriers and falling international trade, declining confidence… And a number of average to mediocre publications, particularly from the most cyclical sectors, cast a somewhat sombre shadow over the landscape. Nothing to be alarmed about, however, for let’s not forget that we’re talking here as bond investors, and that a fall in earnings or sales is a far cry from restructuring, bankruptcy or even a simple spread widening…

And when we say spread, we mean it in pure financial terms, so it is with this point at the crossroads of the other four that we will end this week’s issue by giving a few guidelines for our outlook and bond investments over the coming weeks, the details of which we will give you at our quarterly presentation on September 12:

1. Central banks will cut rates at a relatively sustained pace for 6 to 12 months => the curve will become inverted, money market instruments will lose their attractiveness compared to longer-term bonds.
2. Most investors’ expectations of lower rates, combined with their need to recycle money-market assets with declining returns, are likely to create a major flow into the bond market => it will be preferable to position quickly to take advantage of a potential rally that could be comparable to that of late 2023 on certain parts of the bond market, although part of it has already been realized during the summer.
3. However, central bank rate-cutting scenarios have already been largely taken into account by the markets and could lead to certain exaggerations (cf. end 2023) => long rates are already at equilibrium and will not necessarily all fall, which implies choosing maturities carefully and remaining agile on duration, an attitude that has already borne fruit since early 2023.
4. If central banks are cutting rates, it’s because the economic situation is worsening and companies are more at risk => In this context, bonds, which are the safest asset in a portfolio par excellence, should have a central place in many allocations over the coming months. However, it would be a pity to lose the positive effect of central bank rate cuts through the negative effect of an excessively wide spread linked to worsening economic conditions for companies… We therefore prefer to reduce exposure and be more selective on the riskiest assets, such as high yield or the most subordinated financial bonds, which are highly procyclical and very sensitive in the event of stress, particularly on the longest maturities.

While the topics remain the same, the portfolio applications have adjusted significantly since the beginning of the year, and we’ll be happy to tell you about our allocations for the end of 2024 in a few days’ time.(Registration here, places are limited)

Until then, the Octo AM team wishes you all the best for the new year!