Outlook 2024: Fed rate pause, EM bonds in focus

Cautious optimism or wishful thinking? Only time will tell.

As 2023 draws to a close, there is swelling hope that that the US Federal Reserve’s interest rate hikes have peaked.

While no one is betting on rate cuts just yet, a rate pause seems the next logical scenario.

Inflation is expected to decline globally in 2024 although the trajectory may be bumpy, noted Desmond Soon, head of investment management Asia ex-Japan at Western Asset Management.

“We are the peak for the Fed funds rate, but short-end interest rates may stay at the current restrictive levels for some time as a hawkish Fed seeks to squeeze inflation back to its 2% target,” he said.

That, in theory, should signal the end of the strong momentum in US dollar appreciation and yield increases -- and help local currency assets.

Still, fears that tighter monetary policy conditions will persist well into 2024 continue to weigh on investors’ asset allocation plans.

Many institutions are positioning portfolios with that macro scenario in mind.

EM PLAYS

In a higher-than-normal interest rate environment (compared to the last 15 years), bonds emerged as a top asset class for institutional investors in 2023.

With a rate hike pause in sight, fixed-income investors are turning their attention to emerging market bonds, both local and hard currency.

The backdrop of longer-term risk-free rates in much of the developed markets (except Japan) and an expected soft landing for the US economy suggest segments such as investment grade credits, selected EM bonds including local currency, are likely to outperform in 2024, Soon said.

Cathy Hepworth, head of EM debt at PGIM Fixed Income, noted that the EM rate cycle is already ahead of that of developed markets.

“EM central banks began hiking before the Fed and the European Central Bank, with a few cutting in the second half of 2023, while some are expected to start their easing cycle in H1 of 2024…Most Asian central banks are expected to stay on hold for the foreseeable future given their shallow hiking in 2023,” she said.

Her team is bullish on EM markets given wide valuations and believes “there is enough carry in hard currency to offset any potential short term spread widening from recession fears, and finds attractive risk adjusted return opportunities in resilient sovereigns and corporates in the front-end and belly of curves that are rated BBB and BB.”

Bond selection will cotninue to play an important role. “We see the need for proper selection in the higher-beta issuers within both sovereign and corporates,” added Hepworth.

India bonds could be in favour in 2024 as they join a major global suite of bond indices.
Image credit: Shutterstock

ASIAN BOND APPEAL

Within the EM arena, Asian bonds, US and local currency, are expected to be in play in 2024.

Markets with their own internal growth dynamics could provide more comfort to investors.

Kenneth Akintewe, head of Asian sovereign debt at abrdn, said his team prefers duration risk -- sensitivity of a bond’s value to interest rate changes -- in China, India, South Korea and Indonesia government bonds.

India could certainly get some extra attention from foreign investors: JP Morgan’s decision to include India in its global bond indices in 2024 is poised to attract billions of dollars in foreign fund flows, according to industry experts.

“India bond yields are the highest among Asian high grade sovereign bonds, and we are very constructive on the Indian economy as Prime Minister Narendra Modi, who is widely expected to win a third term in the May 2024 elections, providing stability and continuity to pursue his economic liberalisation and globalisation model for India,” said Western AM’s Soon.

“In addition, India has robust external balances with strong FDI [foreign direct investments] and the world’s fifth largest foreign exchange reserves.”

Foreign ownership of Indian bonds remains very low, contributing to its low volatility and low correlation to other asset classes, and makes them an exceptionally good diversifier for fixed income and multi-asset portfolios, added abrdn’s Akintewe.

Geopolitics is one of the many risks that abound as the world heads into 2024.
Image credit: Shutterstock

VALUE POCKETS

Property could also offer pockets of value as it is further ahead in the cycle, according to Adam Whiteley, head of global credit, insight investment at BNY Mellon IM.

“Given the next phase is likely to involve less growth and lower margins, we prefer non-cyclical sectors such as utilities, and underweight cyclical sectors such as basics and energy,” he said.

Matt Morgan, head of fixed income at Jupiter Asset Management, likes credit that offers exposure to local emerging market growth, such as telecommunications, utilities, banks.

“There is plenty of yield available in solid companies, or countries that benefit from global themes such as nearshoring. The key is to remember that EM countries are much healthier, with more local debt and a stronger domestic asset base, than they were 20 years ago,” he noted in a recently released 2024 outlook.

Nevertheless, a lot of variables persist around the global economy’s prospects and geopolitics, which could affect the performance of fixed-income, despite current expectations.

“Is the US going to have a soft or hard landing? Will China introduce sizable fiscal stimulus and stabilise its property market? How will risks in the geopolitical sphere, i.e. Russia/Ukraine, China/Taiwan, and the Middle East, evolve?

"All of these are still open questions, and the outcomes will likely shape asset market returns going forward,” said PGIM Fixed Income’s Hepworth.