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Our views 15 January 2024

JP’s Journal: Bumpy disinflation

5 min read

Bond markets were little changed over the week; US treasury yields headed lower, ending the week just below 4%.

In the UK, 10-year rates consolidated at 3.8% and in Germany the 10-year bund yield nudged higher, finishing at 2.2%. Overall, however, there was a lack of direction, with investors awaiting more concrete economic evidence.

There was one major economic data release last week. Headline US Consumer Price Index (CPI) inflation for December came in stronger than expected although the core measure was in-line – unchanged from November. Whilst seen as disappointing the release had little market impact. The data supports the view that the disinflation journey is likely to be bumpy. From a bond perspective there has been some easing in the pace of expected rate cuts in recent weeks and the latest CPI supports this. However, the longer term disinflation story still looks intact. With the inflation component related to housing expected to moderate in coming months and Personal Consumption Expenditure (PCE) showing a more marked downward move, there is backing for the current rate cut sequencing. As it stands, investors are pricing in 175 basis points (bps) reduction in Federal Funds rates over the next 12 months.

The direction in the UK is similar although the magnitude is less pronounced – with 125bps of cuts priced. This looks a reasonable differential given the greater flexibility of the US economy. There was some reassurance that the UK could avoid recession with the November GDP release showing 0.3% growth in the month. Service activity was helped by fewer strikes and Black Friday discounting seems have bolstered shopping activity. Overall, the consumer seems to be holding up well, coping with the wet weather better than the construction sector which recorded a fall in output. Recent weeks have seen a fall in fixed mortgage rates which should also be supportive of spending and wider economic activity.

Amongst the headlines grabbing attention last week was the news that Citigroup was planning to cut 20,000 jobs, after posting its worst quarter for 15 years. Part of the disappointment related to one-offs, including the cost of the lifeboat scheme for failed US banks. But there is a wider, and global theme – net interest margins are under pressure. The tightening of monetary policy in the last two years was bad news for some, including Silicon Valley Bank, but good news for big banks. The wave of corporate defaults did not materialise whilst the differential between lending rates and saving rates ballooned. This is now reversing; banks are paying more to attract deposits whilst lending rates are waning. So, expect more emphasis on cost reductions in the next few months.

Last week also saw a review by S&P on credit rating performance in 2023. They noted the intensification of credit pressures with downgrades outweighing upgrades; over 80% of downgrades were in sub-investment grade. Downgrades to issuers in consumer sectors were noticeable (especially consumer products and entertainment) but healthcare also saw downgrades, due to the cost strains of labour shortages. Geographically, the US was at the epicentre of credit rating pressure, in contrast to its relative economic performance. Surprisingly, upgrades outpaced downgrades in Europe. Looking at defaults, the picture is similar. There were 153 failures in 2023, an increase of 80%, with the rise being driven by US defaults. Media and entertainment saw the highest number of failures, representing about 20% of defaults. The outlook, according to S&P, is for a further rise in high yield defaults, to 5% in US and 3.75% in Europe, for speculative grade bonds by September 2024.

We retain a preference for investment grade bonds over high yield at the moment and the picture painted by S&P looks sensible from our perspective. In sterling, investment grade spreads have been widening since Christmas and at the end of last week non-gilt bond indices were showing a spread premium of around 1.2% over gilt yields. Some further widening may be seen if issuance picks up but present valuations look reasonable and we expect the long-term outperformance of sterling credit, over government bonds, to continue.

The increased tension in the Red Sea area is a cause for concern, both from a geopolitical and an economic perspective. Central banks are focused on inflation and if we see disruption to supply chains, rising insurance costs and higher oil prices, it is likely that the consensus around disinflation will be challenged. One to keep a close eye on.


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