Time to shake it off

The rise in interest rates since the start of 2022 has presented multi-asset income investors with numerous challenges. The inflation shock of the past few years translated into one of the most aggressive US Federal Reserve (Fed) rate-hiking cycles in 2022-2023, which in turn contributed to a significant rise in interest rates across the yield curve. Within fixed income, this sent bond prices materially lower (since December 31, 2021, the Bloomberg US Aggregate Bond Index   is down 11.59%¹). Meanwhile, within equity markets, a significant divergence occurred with the “Magnificent Seven” that powered the broad market-capitalization weighted indexes higher in 2023, leaving the average dividend stock in the dust. With the landscape significantly altered, we think it is time for income investors to just “shake it off” and embrace the attractive income and total return opportunities that exist today in both fixed income and equity markets.   

Relative to consensus expectations at the start of 2023, the US economy exhibited notable resilience despite the broad and rapid tightening of financial conditions. We believe there are several key factors that have contributed to growth over the past year, but we question whether these forces can continue to support growth heading into the new year. Even Taylor Swift’s phenomenally successful “Eras Tour” gets some credit for boosting economic activity in 2023. 

As a result of pandemic stimulus efforts—both monetary and fiscal—US households entered 2023 with substantial accumulated excess savings, which supported spending on goods and services. Entering 2024, a significant amount of that excess may be reduced, eliminating one important tailwind for the economy in 2023. As interest rates have risen, the most rate-sensitive areas of the economy were impacted first, including housing, where mortgages increased to levels not seen since 2000. While the impact from higher rates may have been somewhat limited last year, we remain cautious about consumer balance sheets and rising delinquency rates in areas like credit cards and auto loans. 

While the Fed pursued a policy to move interest rates into restrictive territory, economists have long believed that monetary policy tightening acts with a long and variable lag. The broader impact that influences both consumer and corporate spending behavior may just be upon us now as we enter 2024.

As the Fed has pursued a path to rein in inflationary pressures, the investment landscape across fixed-income and equity markets has been meaningfully impacted. Beginning in 2022 and extending through the past year, the rise in interest rates has taken a severe toll on bonds, particularly areas of the markets with longer duration. Looking at both the Bloomberg US Aggregate Bond Index and the Bloomberg US Corporate Bond Index (Investment Grade),   the impact has been severe, with substantial declines in bond prices and a corresponding rise in average current yields. This altered backdrop now offers investors not only active current income, something that we believe can be an important component of overall total returns in a portfolio, but also the potential for attractive total returns as policy shifts from restrictive to either neutral or one of accommodation if the economy were to experience sluggish growth or recessionary conditions.  

Our preferred asset exposures within fixed income heading into 2024 include US Treasury securities across the yield curve, and investment-grade corporate bonds where refinancing risk is muted and balance sheets remain strong. While high-yield bonds offer attractive yields, selectivity is as key as any material weakening in economic conditions that could pressure credit spreads and make access to capital markets more uncertain for many companies with non-investment-grade ratings.

As equity markets experienced narrow leadership for much of the past year, many sectors and companies underperformed due to pressure from negative earnings revisions and higher rates, which can have the effect of lowering valuation multiples. Looking forward, we believe the potential for further reduction in consensus earnings estimates exists for many companies as the economy feels the full effect of tighter financial conditions. 

Additionally, as interest rates rose in 2023, dividend stocks underperformed due in part to the more mature or interest-rate sensitive nature of their businesses. While we meaningfully favor fixed income over equities right now,   we remain diligent in looking for opportunities where valuations more appropriately discount the potential slowdown in growth that we believe will characterize markets in 2024.

Despite the challenges investors may face in the coming year, we are sanguine about the prospects for income and total return given today’s higher yields and the fact that many bonds are trading below their face value. Additionally, the broadening of the income opportunity set offers the potential for increased diversification in our portfolios and provides us with a bigger tool kit to attempt to manage the risks with an uncertain market backdrop. The historic rise in interest rates from the extraordinarily low levels of just a couple of years ago has pressured income-oriented investments. With much of that in the rearview mirror entering 2024, in our view, investors should just “shake it off” and embrace the attractive income and total return opportunities that exist today in both fixed income and equity markets.