CONTRIBUTORS
David Zahn, CFA, FRM
Head of European Fixed Income,
Portfolio Manager
United Kingdom
2023 has set the stage…
The European Central Bank’s (ECB’s) unprecedented streak of 10 consecutive policy rate hikes has led to a slowing of economic growth in the euro area (EA). Credit conditions have continued to tighten, and sentiment indicators are still trending lower. Meanwhile, headline inflation is easing and reached a two-year low in October. Despite services putting some upward pressure on core inflation, the overall trend is one of deflation.
…for optimism going into 2024.
We believe that economic growth in the EA will stagnate over the coming quarters, before picking up toward the end of 2024. Although the manufacturing sector is feeling the squeeze, and lower fiscal spending in the year ahead should weigh on growth, we expect rising real wages to help mitigate a more severe downturn. The unemployment rate in the region remains near record lows and, in our view, will likely increase only marginally over the coming months. The job market is showing signs of cooling, but labor shortages are still at levels conducive to labor hoarding and should support wage growth going forward.
The ECB’s conviction is that its current monetary policy setting, if maintained for long enough, is sufficiently restrictive to bring inflation back to its target. As such, we now expect a prolonged pause before any further decisions are made. In our opinion, policymakers will want to see second-round inflation effects on wages fade before embarking on monetary policy easing. Consequently, we are penciling in a first rate cut for the third quarter of 2024. However, persistently higher energy prices could pose some upside risks to inflation and potentially delay the start of an easing cycle.
Overall, declining yields should provide a tailwind for European fixed income in the coming year, particularly when compared to the United States where robust consumer spending continues to support a resilient economy. It is therefore our view that the ECB will likely cut rates ahead of the US Federal Reserve (Fed), as it is forced to respond to lackluster growth.
Our thoughts on portfolio positioning:
Given this backdrop, our thoughts about fixed income portfolio positioning going into the new year are as follows:
- Lock in yields
Interest rates have been moving higher over the past two years and are set to decline in 2024. We are therefore seeing investors starting to lock in the currently attractive yields that hover near multi-year highs. A reallocation toward longer-duration assets can also help to reduce the reinvestment risk present with the recently popular money market funds, especially in a falling rate environment. - Extend duration
Weakening growth and a sustainable downward trend in inflation suggest that policy rates in the EA have very likely peaked. Therefore, this is an opportune time for investors to start extending the duration of their fixed income holdings. We believe green and social bonds, which are typically issued to fund longer-term projects, are a good source of longer-duration investments. - Consider sustainable investing
An expanding and increasingly diverse sustainable finance market means that attractive returns can go hand in hand with a positive impact on the environment and our communities. We expect demand for green and social use-of-proceeds instruments to remain strong going forward, with both markets set for dynamic growth. Sustainable investing will be a dominant trend in the coming years, in our view, with structural tailwinds that could help improve financial returns.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal.
Fixed income securities involve interest rate, credit, inflation and reinvestment risks, and possible loss of principal. As interest rates rise, the value of fixed income securities falls.
Green bonds may not result in direct environmental benefits, and the issuer may not use proceeds as intended or to appropriate new or additional projects.
International investments are subject to special risks, including currency fluctuations and social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.