3 Factors Likely to Drive Fixed Income Markets in the Near Future

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So far this year, the macro backdrop for fixed income markets has been ever changeable, reflecting the uncertainty and volatility that investors have had to navigate. The market narrative has been a roller coaster, jumping from one concern to the next, month after month. As we reach the halfway point of the year, it is crucial to understand the factors that are shaping these markets and how they affect fixed income investment decisions.

To shed light on these issues, we enlist the expertise of Colin Finlayson, fixed income portfolio manager for Aegon Asset Management’s strategic global bond strategies. With an insider’s view, Colin analyzes three key factors that are driving fixed income markets today: inflation, economic growth and the interest rate policies of the major central banks. His analysis will give us a better understanding of the underlying dynamics and how these may influence fixed income investment strategies in the coming months.

Starting with inflation, what have you seen so far this year and what are your expectations for the second half of the year?

Inflation has probably been the most important news so far this year, especially in the United States. We have seen the steady decline in inflation become a bit slower and stickier. And this has raised some concern about the degree of interest rate cuts the Fed will be able to implement this year. The Fed’s preferred measure, the underlying PCE deflator, has been moving gradually lower. But the question is whether it is moving enough for the market.

Across the Atlantic, the story is quite different. Inflation has been surprising to the downside fairly steadily in Europe, and the UK is seeing inflation return to the Bank of England’s target, having recently hit 11.1%. This continued decline in inflations is help give some confidence to fixed income markets and is offering support to the outlook for government bonds and therefore broader bond market yields.I wanted to ask you about growth… What is your outlook for growth and how does it affect fixed income investors?

There has been an ongoing debate about whether we are going to see more of a soft landing for economic growth or more of a no-landing scenario where growth starts to reaccelerate. In Europe and the U.K., we have clearly been on a soft landing trajectory as growth has been at more recession-like levels, unemployment has started to rise and the impact of higher interest rates is starting to be seen in household demand and spending.

In the United States, however, growth has been somewhat more robust. The US has benefited from greater resilience in the labor market, but also from earlier fiscal spending, which has been percolating through the system. During the first few months of this year, it looked like there were going to be steady upside surprises in US GDP. But in fact, first quarter growth was weaker than expected and was revised down again in its most recent reading. So in the US, which looked set to deliver more upside surprises, growth is starting to moderate, which is reflected in business surveys, such as the ISM, which are starting to soften. The idea of a soft landing is starting to become more apparent in the US and, again, this is a backdrop that would be more beneficial for bond markets than a no landing scenario, which was feared earlier this year.

I wanted to ask you about growth… What is your outlook for growth and how does it affect fixed income investors?

As far as official interest rates are concerned, central banks are now considering only two paths: hold them or cut them. The European Central Bank (ECB) has already lowered rates along with the Bank of Canada, the Riksbank and the Swiss National Bank, and we believe other central banks will follow suit. With monetary policy at tightening levels, there is no need to keep rates at these elevated levels for an extended period of time. We believe that the Bank of England will be the next major central bank to cut rates and that the US Federal Reserve will follow.

From a fixed income investor’s point of view, the fact that we are talking about rate cuts rather than rate hikes is the most important factor. With growth slowing and inflation returning to target, we expect interest rates to come down at a gradual pace in the coming period. And this will help support fixed-income markets over the next 12 to 24 months.

How do these factors influence the management of Aegon Asset Management’s fixed-income portfolios?

The macroeconomic backdrop is constantly changing, and we try to cut through the noise to construct portfolios with a long-term view of where we believe there is value in fixed income markets. Strategic global bond portfolios are designed to be flexible and unconstrained and can use their flexibility to take advantage of anomalies that arise as data evolves and market value changes. Given our outlook for inflation, growth and interest rates, we believe portfolios with a more flexible approach are well positioned to benefit from changing market conditions over the next 12-24 months.

 

Four Trends Hovering Over the Market: Geopolitics and Economic Transformation, Sustainability, Technology, and Demographics

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Amundi Shares Key Insights from the 2024 Edition of its Global Forum, Amundi World Investment Forum. The event featured in-depth discussions on geopolitical issues, economic transformation, major global macroeconomic trends, and their implications for investment.

In her opening speech, Valérie Baudson, CEO of Amundi, shared her convictions about the state of the world: “The economic outlook is improving, with global GDP growth around 3% in 2024 and 2025. Meanwhile, history and geopolitics are back in focus, with energy transition and technological innovations at the center of geopolitical tensions, as they condition nations’ ability to maintain or gain power.”

The firm shared several key conclusions. The first is that major political and economic changes threaten long-standing trade and security alliances. According to the firm’s perspective, global politics affecting economies was a prominent theme among the speakers. Sanna Marin, Prime Minister of Finland (2019-2023), focused her talk on the current conflict in Europe, stating, “A major game is being played between democracies and authoritarian regimes. What is happening in Ukraine will define the future of democracy.” She urged Europe and NATO to offer “broader perspectives” and reminded that “geopolitics is not the only threat facing humanity; climate change and biodiversity loss are also critical.”

Adam S. Posen, President of the Peterson Institute for International Economics, predicted, “Markets will push interest rates up in the coming years.” Ricardo Reis, A.W. Phillips Professor of Economics at the London School of Economics, explained public debt movements by three factors: “The large current account deficits of China and the rest of Asia caused a significant capital flow into Europe and the United States, investment stagnation due to very few opportunities in the 2010s, and the perception of government bonds as very safe with little inflation risk. Today, all three factors have reversed.”

Additionally, Keyu Jin, Professor of Economics at the London School of Economics, estimated that “the three fastest-growing economies in the coming years will be in Asia: China, India, and Indonesia,” and spoke about “the need for convergence” in the region: “China has room to converge with richer countries, and India also has enormous room to converge with China.”

Gordon Brown, Prime Minister of the United Kingdom (2007-2010) and Chancellor of the Exchequer (1997-2007), concluded the first day of debates with a message of hope, stating, “Even in the most difficult circumstances, even when things are very dark, we must keep hope alive. There are still signs of hope in this global economy that we must build upon, as Mandela said, ‘building for the future.’”

Sustainability, Technology, and Demography

The decarbonization of economies was a major focus. Dinesh Kumar Khara, Chairman of the State Bank of India, highlighted the “immense” potential of his country: “We are now embarking on green energy, which is being adopted significantly.”

Two case studies were presented: Chee Hao Lam, Chief Representative of the Monetary Authority of Singapore at the London Office, discussed how Singapore articulates public policy and mobilizes investors to finance the energy transition. Dr. Kevin K. Kariuki, Vice President of Power, Climate, and Green Growth at the African Development Bank Group, spoke about financing green energy infrastructure in a continent that “needs $25 billion annually to achieve universal access to modern energy by 2030.”

The firm also reflected on how the rapid acceleration of technological development has created new opportunities and pressures. Maurice Levy, Chairman Emeritus of Publicis Group, opened the second day’s debate with a focus on the rise of generative artificial intelligence. In his view, “On one hand, people think AI is probably the dream of tomorrow, which will change lives, especially for companies, their productivity, and profitability. At the same time, there is fear of job cuts and replacement, but most importantly, we need to address the implications regarding the use of deepfakes in democracy.”

Daron Acemoğlu, Professor at the MIT Institute, stated, “The key decision for CEOs will be how to use AI with workers, with human resources: whether they see workers as a cost to be cut or as an important resource that will contribute to their company’s success.” Aurélie Jean, Ph.D. and Computational Scientist, entrepreneur, and author, complemented this statement: “AI does not sufficiently protect workers. Technology owners, developers, scientists, and engineers have a responsibility to provide users with the correct information; they must protect while also fostering innovation.”

Experts remind us that financial services are at the heart of the AI revolution. “There is a huge opportunity to turn European savers into future European investors, and if AI can help with that, it will contribute to a better society,” said Dr. Kay Swinburne, Baroness of Swinburne.

Finally, the firm believes that demographic change is influencing many aspects of our lives. Mauro Guillén, Professor of Management and Vice Dean at the Wharton School, stated, “The key question is how to ride the wave of demographic transformations. India will soon have the largest consumer market in the world due to its younger population, although China will have the largest economy.” Demographics will impact investment trends, as “most of the world’s wealth, between 60% and 80% depending on the country, belongs to people over 60 years old.” Hence the need for “investment platforms to be safe, educational about risks and opportunities, and accessible” for all.

Liquidity Challenges in Private Equity: Where are the Bright Spots?

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Pixabay CC0 Public Domain

If there’s one topic that has dominated the minds of private equity investors in recent months, it’s liquidity. It is so present that you can now even buy T-shirts on Amazon emblazoned with the phrase “DPI is the new IRR”. DPI, or Distributions to Paid-in Capital, measures how much capital a fund has returned to its investors relative to what has been called. Putting DPI ahead of the industry’s widely promoted performance metric IRR (Internal Rate of Return) sends a clear message to managers: stop focusing on returns and start selling stakes to generate liquidity.

The private equity industry is currently experiencing a severe downturn in deal activity. According to S&P Global Market Intelligence, global deal volume fell by 34.7% year-on-year in 2023, reaching its lowest level in five years. Economic uncertainty, public market volatility and geopolitical tensions have made General Partners (GPs) hesitant to sell their stakes, fearing they won’t achieve their desired outcomes. IPOs, in particular, have been almost nonexistent over the past 12 months. As a result, many LPs have received significantly less capital back than in previous years.

Sustained Interest in Private Equity

Distributions from successful exits are, in general, a meaningful source of capital for investors to meet calls on previous commitments. Pension funds, insurance companies and other large investors typically rely on this liquidity stream as they often adhere to allocation guidelines that limit their exposure to alternative investments. When GPs extend their holding periods beyond the typical timeframe, these LPs not only must seek alternative liquidity sources but also face a temporary reduction in their ability to make new commitments to the asset class.

To fully grasp investors’ growing impatience with private equity managers, it is worth looking at the current market phase we are in. Historical data shows that funds launched immediately following recessionary periods have consistently outperformed their peers. Bain & Company has compiled a comprehensive overview of the annual returns achieved by global buyout funds since 1993. For instance, after the dotcom bubble burst, the average IRR for buyout funds was 25% in 2001, 40% in 2002, and 48% in 2003. Similarly, following the global financial crisis, the IRR was 22% in 2009.

Investors Favor Lower Mid-Market Buyouts

Now, with inflation seemingly under control, the European Central Bank has recently initiated its first interest rate cut, setting the stage for an expected economic rebound. LPs also appear to be anticipating a turnaround, as interest in the asset class remains strong. A survey by Natixis of 500 institutional investors globally reveals that over a third plan to increase their private equity allocations in 2024.

However, today’s LPs are more discerning. Unlike in previous years, when money was cheap and almost all private equity segments were thriving, they are now carefully evaluating which sub-segments to include in their portfolios. Recent surveys shed light on the lessons they may have learned from recent market turmoil. Rede Partners, an advisory firm specializing in alternative investments, reports that 50% of institutional investors plan to increase their commitments to lower mid-market buyouts – funds focusing on majority stakes in small and medium-sized companies. A further 46% favor mid-market investments. Large-cap funds, by contrast, are less preferred, with only 10% planning to increase their allocations in 2024.

Stable Distributions Due to a Larger Buyer Pool

Smaller deal sizes naturally lead to a larger pool of potential buyers compared to the large-cap segment where IPOs are often one of the very few available exit channels. Lower mid-market managers typically sell their stakes to a wide range of financial or strategic investors, such as competitors; exit channels that have – for high quality assets – remained open despite the numerous macroeconomic challenges. As a result, distributions to LPs have been relatively stable in the lower mid-market.

That said, the rising appeal of the lower end of the market can also be attributed to additional structural advantages, which become particularly apparent in challenging times. By far the most important is the greater potential for value creation through operational and strategic measures. Medium-sized companies are typically more flexible than large corporations, allowing them to respond quickly to current challenges and seize short-term opportunities, particularly when working alongside an experienced private equity investor. In addition, entry prices and leverage ratios are typically lower, leading to an attractive risk-return profile.

Focus and access are key

Yet it is important to recognize the remarkable heterogeneity of the lower mid-market, characterized by a wide range of manager performance. And: Access is crucial. Managers with proven track record in navigating economic turmoil are in high demand, continuing to complete their fundraising in record time and with significant oversubscription. Given the ongoing economic complexities, we expect to see an even greater concentration on this group of exceptional managers. As a result, focus and access will become increasingly critical to investment success.

A Strengthened Trump Could Translate Into Higher Demand for Safe-Haven Assets and More Risks in the Markets

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The failed assassination attempt on Donald Trump this weekend during a rally in Pennsylvania brings a new direction to the US presidential race, improving his chances of victory. Additionally, according to experts, this event, which has dominated headlines since Saturday, could lead investors to seek safe-haven assets such as the dollar, gold, the Swiss franc, government bonds, and high-quality stocks.

In the opinion of Christian Gattiker, Chief Analyst at Julius Baer, regarding the political impact, Donald Trump’s election chances have increased dramatically. “If successful, this would mean a shift towards a more risk-taking mode in the markets, with higher expected growth in 2025 due to lower taxes and business-friendly policies,” he points out.

The experts at Renta 4 Banco share a similar assessment in their daily morning report: “The assassination attempt on Donald Trump this weekend could strengthen his chances of victory in the November presidential elections, as well as further increase political tension in the US.”

Bloomberg adds that it not only strengthens Trump’s position but also opens a new front for his opponent. “US President Joe Biden now finds himself fighting a re-election battle on two fronts: against Donald Trump and, more immediately, against some skeptics in his own party.” In this regard, Biden insisted to the press during Thursday’s press conference following the NATO meeting in Washington that “I am determined to run, but I think it’s important to allay fears.”

So far, around 20 Democratic House members and one Democratic senator, Peter Welch of Vermont, have publicly called for Biden to withdraw from the race against 78-year-old Trump, according to Bloomberg’s count.

Regarding the market, the Chief Analyst at Julius Baer believes that “it is quite possible that safe havens such as the US dollar, gold, the Swiss franc, seemingly safe government bonds, and high-quality stocks will be sought in the short term.” However, Gattiker clarifies: “If we believe the well-informed experts on US politics, the realization that Donald Trump’s election chances, and those of the Republicans in general, have significantly improved could settle in quickly, possibly even during the Republican National Convention this week. It is quite possible that we will see an iconic image of a raised fist against a bright blue sky as a defining moment of this campaign and beyond, which could be seen as a decisive moment in the election. This, in turn, would mean a shift towards a more risk-taking mode in the markets, with higher expected growth in 2025 due to lower taxes in the US and more business-friendly policies. How quickly this turnaround can occur largely depends on how quickly and successfully the Republicans can turn this shock into political capital,” he argues.

Inflation Data for June in the US: Is It the Clear Signal the Fed Was Waiting for to Lower Rates?

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Markets and investors are confident that the US Federal Reserve (Fed) will announce a first rate cut in September. The argument supporting this conviction is the positive inflation data for June in the US: the year-over-year headline indicator showed an increase of 3%, lower than the expected 3.1% and down from 3.3% the previous month; and the core CPI surprised with a cut of one-tenth from the previous figure, reaching its lowest level since April 2021.

“On a monthly basis, the headline rate turned negative for the first time in nearly four years, with a -0.1% versus the expected 0.1% and the flat variation of the previous month. Overall, this confirms the trajectory towards the 2% target, although fluctuations may occur in the coming months,” explain analysts at Banca March.

By components, Banca March notes that both services and goods contributed less to inflation. “For services excluding energy, the variation was only 5%, the lowest rate since April 2022, contributing 3% compared to 3.11% the previous month. This was mainly due to a significant slowdown in attributed rents: 5.4% in June, the lowest growth since May 2022, compared to 5.6% previously, contributing 1.4%. As for goods prices, they declined at a rate of 1.84%, the biggest drop in 20 years, thus subtracting 0.40% from inflation. Finally, there was also a sharp slowdown in energy, growing by 0.99% compared to 3.67%, contributing only 0.08% versus 0.26%,” they detail in their daily analysis.

According to Banca March, it is undeniable that this is a good data point, reflected in market behavior. “It boosted bond prices on both sides of the Atlantic, leaving 10-year rates in the United States at their lowest levels since late March, and in Germany, the 2.5% level was breached again. Additionally, interest rate futures raise the chances of cuts in September to 90%, making it practically certain,” they add.

September: Rate Cut

In light of this macroeconomic data, combined with the outlook on the labor market and the US economy presented by Fed Chairman Jerome Powell this week during his testimony before the Senate Banking Committee, the first rate cut in the US is set for September. According to Ronald Temple, Chief Market Strategist at Lazard, at this point, a rate cut in September should be a “done deal.” “In the second quarter, the overall inflation rate in the US was 1.1%, with core inflation at 2.1%, making it increasingly evident that the upward surprises in the first quarter were anomalies. Given the growing evidence of slowing economic growth, it is time for the Federal Reserve to refocus on the dual mandate and ease monetary policy,” Temple argues.

For John Kerschner, Head of US Securitized Products and Portfolio Manager at Janus Henderson, both the headline and core CPI were weaker than expected, giving the Federal Reserve the unequivocal signal that it will start lowering rates by the end of the year. “With less than three weeks until the next Fed meeting, the market is currently pricing in that it will skip that meeting and make its first cut in September. The probability of a cut at that meeting is now close to 100%, according to the market. More importantly, the market now expects three cuts by the end of January 2025. Chairman Powell recently said that inflation risks are now more ‘balanced.’ Yesterday’s figure reinforces that view and may now tilt the balance toward concern over a sharper slowdown in the US economy,” Kerschner states.

There is a clear consensus that weaker US inflation data strengthens the case for a rate cut at the September Federal Open Market Committee meeting. “Along with softer economic data, including a cooling labor market, this has increased confidence that inflation will tend to decline in the coming months. We lower our US inflation forecast to 3% in 2024 and 2.2% in 2025. We still expect the Federal Reserve to cut rates in September and December 2024,” acknowledges David Kohl, Chief Economist at Julius Baer.

According to Kohl, the decline in inflation in June follows a moderation in May and reinforces the view that the Fed will cut the federal funds rate target at its September meeting. “Weaker economic data, including a cooling labor market, also increases our confidence that inflation will decelerate further in the coming months and that the Federal Reserve will cut the target rate again at its December meeting. We lower our annual inflation forecasts for 2024 from 3.2% to 3.0% and for 2025 from 2.3% to 2.2%,” he concludes.

However, there are also dissenting voices in the industry. According to experts at Vanguard, despite the turn taken by the unexpected strength of the US economy, the events of the first half of 2024 have reinforced their view that the environment of higher interest rates is here to stay. “The current economic cycle is not normal. The global economy is still settling after unprecedented economic shocks that include a pandemic, a war in Ukraine, and rising geopolitical tensions. Structural changes, such as an aging population and rising fiscal debt, also make it difficult to decipher the economic cycle from the trend. This creates a challenging environment for central banks, markets, and investors,” says Jumana Saleheen, Chief Economist for Europe at Vanguard.

CME Group and CF Benchmarks Announce Two New Cryptocurrency Indices

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CME Group and CF Benchmarks announced plans on Thursday to launch two new cryptocurrency reference rates and real-time indices for Ripple XRP (XRP) and Internet Computer (ICP), which will be calculated and published daily by CF Benchmarks starting July 29.

These reference rates and indices are not tradable futures products.

“These new reference indices are designed to provide clear and transparent pricing data to a wide range of market participants, enabling them to more accurately value portfolios or create structured products,” said Giovanni Vicioso, Global Head of Cryptocurrency Products at CME Group.

With 24 cryptocurrencies in our suite of CME CF Reference Rates and Real-Time Indices, “we will provide pricing data across more than 93% of the investable cryptocurrency market capitalization, helping clients around the world better manage their risk,” Vicioso added.

As with all CME CF Benchmarks reference rates and real-time indices, these new reference indices will use price data from major cryptocurrency exchanges and trading platforms that are currently constituent exchanges of the CME CF Benchmark reference rate and real-time index suite, the statement said.

Each of the new reference indices will be calculated using price data from a minimum of two of the exchanges Bitstamp, Coinbase, Gemini, itBit, Kraken, and LMAX Digital.

“CF Benchmarks is proud to continue supporting the expansion and maturation of this asset class as clients begin to distribute their activity across a wider range of cryptocurrencies,” said Sui Chung, CEO of CF Benchmarks.

Each of these new reference indices will provide the price in US dollars of each digital asset, published once a day at 16:00 London time, while each respective real-time index will be published once per second, 24 hours a day, 365 days a year.

From Slogan to Numbers

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This week marks the beginning of the Q2 earnings reporting season in the U.S.

Approximately 42% of S&P 500 companies (213 in total) will report their performance by the end of the month. As usual, banks will be the first to report and are expected to detract the most from overall financial sector earnings growth (-10%), whereas excluding banks, the aggregate earnings per share (EPS) for insurance companies, capital markets, and other financial services firms would increase by ~15% (compared to the 4.3% estimated by consensus for the industry).

At first glance, the performance of banks (BAC, C, WFC, JPM) will likely be similar to the previous quarter. The yield curve remains inverted, long-term bond yields have increased by 0.17% during the period (compared to a 0.3% rise in the first three months of the year), loan growth continues to moderate, and while net interest income will also maintain a moderate growth rate, management teams might provide positive comments regarding a bottoming out of the margin. More clarity on the news reported by Reuters about comments on Basel III “Endgame” capital rules by the Fed would boost the share prices of major banks.

Broadening the perspective, according to S&P data, the consensus among analysts expects S&P 500 EPS to grow by 5.74% for the April-June quarter compared to the same quarter last year. Strategists and managers are betting on a positive EPS surprise below the average of recent quarters, placing this growth in the 7% – 8% range. The twenty companies that have pre-announced have reported ~+4% above consensus, justifying this bet.

The numbers are heavily skewed towards the contribution of the technology and communication services sectors. Earnings for Microsoft, Amazon, Apple, Meta, Nvidia, and Alphabet are expected to grow by 32%, while non-tech industries will only grow by ~2%. This starting point increases uncertainty regarding the outcome of the quarterly performance announcements because, on one hand, the EPS growth of these tech companies is slowing down (from 68% in Q4 2023 to 56% in Q1 this year). On the other hand, margins are unlikely to improve much further.

The consensus projects operating margins of 12.5% for the S&P (an increase of 5.3% from last year, still below the 2021 peak of 13.54%), with a 30.87% contribution from technology and communication services.

Therefore, it is important to pay attention to the comments from the management teams of hyperscalers regarding their plans to deploy around $200 billion in capital investments, with a significant portion associated with generative AI developments announced last quarter.

Everything has its limits, and while generative AI remains a priority for tech companies from an investment perspective, monetary commitments of this magnitude could negatively impact return on invested capital (ROIC) if not adequately monetized, and this is not simple or quick to achieve.

Nvidia’s cadence in launching new products helps build an AI offering more efficiently in the medium term, although in the short term, the price to pay starts to concern investors.

Blackwell, Nvidia’s new GPU chip, which will be marketed around 2025 and installed in the AI server GB200 NVL72, provides up to 30 times more performance than a rack configured using the same number (74) of Hopper GPUs (H100, the model preceding Blackwell) for large language model inference, while reducing energy consumption per computing unit (FLOP). The new system is also four times faster in training AI models than the previous version. However, these impressive improvements are not cheap. The price of two 16 GPU H100 systems is $400,000, and according to some analysts, the GB200 NVL72 could cost $3.8 million.

Nvidia is undoubtedly the clear winner in the AI leadership race, as demonstrated by its numbers. Analysts estimate more than $200 billion in revenues for the data center business by 2025, which generated $48 billion in 2023, translating to a compound annual growth rate of 63%. However, according to a Morgan Stanley survey of Chief Information Officers, AI investment momentum is slowing, and passing on such significant price increases to customers, despite efficiency improvements, may become more challenging.

Experts in the field expect continued spending on increasingly costly and complex large language models (LLM) development, which could cost between $10 billion and $100 billion by 2027, according to the CEO of Anthropic in this interview. And investors have no reason to doubt.

If Microsoft, Alphabet, Meta, or Amazon suggest slowing their investments or taking a more patient approach, these same investors might start to waver.

As explained earlier, the good performance and maintenance of guidance by tech companies are necessary for analysts to maintain their aggressive earnings growth targets, averaging 12.85% per quarter for the next five quarters. This is possible but increasingly challenging if, as mentioned last week, the recovery in industrial activity begins to cool.

Arguments in favor of a first rate cut in the U.S. in September are mounting after Thursday’s CPI and Jerome Powell’s comments: the Fed chair stated in his testimony this week that inflation “is not the only risk we face.” However, while the compression in public debt yields benefits the valuation of growth companies like software or semis, managers seem too focused on the return of disinflation but not enough on the slowing growth – which is becoming increasingly evident – and the volatility that the presidential campaign will bring starting in September.

Biden’s intervention at the NATO meeting was much more solid than his debate with Trump, and his intention is to run for re-election, although there are increasing domestic (both political and non-political) and international pressures for him to step down.

The aggregate polling provided by RealClearPolitics gives Donald Trump a 47.2% voting intention compared to 44.2% for Joe Biden. Although isolated polls like ABC News (46-46) or Reuters/Ipsos (40-40) show a more uncertain situation, Trump still has the electoral college count on his side, even if he loses the popular vote. Of the 10 states that could tip the balance – with results within 5 points – he would emerge victorious in 7 of them.

Jensen Huang, CEO of Nvidia, said at his developer conference in California that, despite the rising cost of their GPUs, “the more you buy, the more you save.”

The math is correct, but investor sentiment’s volatility and a less dynamic economic activity could suddenly shift investors’ focus from the slogan to the numbers.

Arguments in Favor of Local Currency Emerging Market Debt

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So far in 2024, local currency emerging market (EM) debt has generated a negative return; however, this should be viewed in the broader context of the prevailing interest rate and currency environment, says a Colchester report accessed by Funds Society.

A simple comparison of the standard index for local currency EM debt (the JP Morgan GBI-EM Global Diversified) with the FTSE World Government Bond index of investment-grade government debt shows that local currency EM debt has not underperformed in relative terms.

It is also worth considering the composition of the return of local currency EM debt, which can be broken down into the return from the local currency bond markets themselves, and the impact of currency changes. This breakdown demonstrates that the negative return so far in 2024 is entirely due to currency weakness.

The JP Morgan GBI-EM Global Diversified index return in local currency terms is positive year-to-date, while the return in USD-hedged terms is a reasonable 0.74%. This shows that EM currencies have, on average, declined against the US dollar, which has appreciated against most currencies during the period.

Outlook for the Asset Class

Regarding the outlook for the asset class, we analyze the two return drivers separately, i.e., the currency component and the underlying bond return (which in turn can be broken down into price return and interest yield). Previous Colchester analysis clearly shows that a rising US dollar environment tends to be difficult for local currency EM debt, and conversely, a weakening US dollar tends to coincide with relatively strong asset class returns.

The US Dollar Cycle

Historically, the direction of the US dollar has been closely linked to the performance of EM assets. When the dollar strengthens, this often coincides with a tightening of global financial conditions that pressures EM economies with weaker balance sheets, current account deficits, or foreign capital dependencies. It also tends to cause currency weakness among EM currencies, exerting upward pressure on EM inflation and deteriorating credit quality. This mechanism also unfolds to varying degrees in the developed world.

The last two decades have seen two distinct US dollar cycles: (i) depreciation in the first seven or eight years of this century, and (ii) significant appreciation from 2011 to 2022 (though upwardly extended). The dollar also went through a consolidation period between 2008 and 2011. These three periods can be seen in the following chart.

When observing the respective USD returns of local currency and hard currency EM bond classes during these periods, it is not surprising to see that they are highly correlated with the dollar’s direction. The hard currency index outperformed the local index when the dollar strengthened and underperformed when it weakened. In absolute terms, local currency debt produced attractive positive returns during both USD weakness and consolidation periods, but performed poorly during the USD strength period.

There are other elements in play, such as the widespread global inflation of 2021/22, but nonetheless, the following chart demonstrates a statistically significant relationship between US dollar movements and local currency EM debt index performance. Looking ahead, this raises the question of what the likely trend of the US dollar will be.

As a cornerstone of our currency valuation framework, we believe that the real exchange rate provides a useful metric for assessing relative currency value in the medium term. Our current assessment of the US dollar’s real value suggests that it may have peaked towards the end of 2022 and could be entering another depreciation cycle similar to the 2000s.

Colchester estimates that the dollar reached a real overvaluation of nearly 30% against a basket of five major developed world currencies at the end of 2022. While the dollar has weakened slightly since then, it has strengthened again in the first six months of this year, meaning it remains extremely overvalued according to our real exchange rate analysis. Relative purchasing power parity theory and empirical evidence suggest that the US dollar is more likely to weaken than strengthen in the medium to long term.

Turning points are notoriously difficult to identify ex-ante in all financial markets, and perhaps even more so in currency markets. Nonetheless, besides the extreme overvaluation of the real exchange rate, there are other indications that we may have seen the peak of the US dollar in this cycle. For one, the interest rate differential between the US and other major economies is no longer widening. Broad money growth (M2) in the US remains moderate, suggesting that absent a commodity price shock, inflationary pressures are not rising. Indeed, core inflation is likely to continue to decline gradually from current levels, and markets are once again contemplating the timing of potential Fed rate cuts.

Colchester’s outlook for the US dollar is not based on a forecast of monetary policy easing; in fact, we do not make official rate forecasts at all. However, we firmly believe that real exchange rates are a key factor in long-term exchange rate variations, and this indicates to us that the US dollar may be entering a period of depreciation.

EM Inflation and Real Yields

The second component of local currency EM debt returns is obviously the performance of the local bond markets themselves. In Colchester’s framework, prospective real yield is a value indicator, so we must consider inflation prospects in the EM universe and the level of real yield on offer.

Certainly, there was an increase in inflation in Latin America and Central Europe in response to post-pandemic supply chain disruptions, aggressive stimulus, and high food and energy prices. The experience in Asia was more varied, but upward inflationary pressure materialized in certain economies. However, it is noteworthy that as global inflationary pressures have subsided, inflation has decreased in EMs at a similar, if not faster, pace than in some developed markets. Particularly in Latin America, inflation has followed a clear downward trajectory after peaking in 2022 in economies like Brazil, Mexico, and Chile.

This disinflationary process in many major EMs is not surprising, given the pace and scale of monetary policy adjustments undertaken. Many EM central banks were not only more conservative than their developed market counterparts in response to the COVID-19 shock but also much more aggressive in tightening policies in the face of deteriorating inflation prospects. In Brazil and Colombia, for example, central banks began raising rates about 12 months ahead of the Fed.

As inflation has decreased, several EM central banks have begun easing cycles, but importantly, real interest rates remain relatively high. In Brazil, for example, the latest inflation figure was 3.9%, while the official rate remains 10.5%. In Colombia, inflation is 7.2%, and the policy rate is 11.25%, while in Hungary, the latest CPI was 4.0%, and the policy rate is 7%. Given Colchester’s inflation forecasts for most EMs imply stable or declining inflation, the level of prospective real yield across the curve remains significant. This makes these markets attractive both in absolute terms and relative to their developed world counterparts, including the US.

Valuation of Potential Real Yields

Colchester’s prospective real yield and real exchange rate valuation approach provides a framework within which to evaluate potential medium-term local currency debt returns. Both benchmark bond and currency exposures and Colchester’s program exposures can be translated into potential real yield by multiplying their respective weightings by the prospective real yield and real exchange rate on offer in each market. This provides a metric that can be assessed over time.

The current “value” on offer in both the JP Morgan GBI-EM Global Diversified index and Colchester’s local currency program is near historic highs. The attractive prospective real yields on offer across the opportunity set, combined with the undervaluation of EM currencies relative to the US dollar, make a compelling valuation case relative to history. Positive inflation prospects, along with high nominal yields on offer in many EMs, suggest a potential real bond return of over 3% in the benchmark index, and closer to 5% in the Colchester program. Similarly, the sustained undervaluation of EM currencies’ real exchange rate against the US dollar by about 18% in the benchmark, and around 22% in Colchester’s currency exposures, suggests another 3% and 4%, respectively, of intrinsic value on offer on the currency side.

Combining these suggests a potential real yield of around 7% in the benchmark index and around 9% in the Colchester program. As the following chart highlights, both compare favorably with an average of around 3% and around 5%, respectively, since the inception of the Colchester program in January 2009. A similar analysis in relation to the euro shows a similar picture. The value on offer is slightly lower in absolute terms, given the euro’s undervaluation against the US dollar, but the prospective real yield of the strategy remains a healthy 6.4% in euro terms.

Relative to its history, this metric (whether in USD or euro terms) suggests that local currency debt currently offers attractive value.

Conclusion

Compelling prospective real yields, prudent monetary policy, greater macroeconomic stability across much of the local currency EM debt space, and significant real currency undervaluation provide a positive context for the asset class going forward. Local currency EM debt should perform well in this environment, especially if the US dollar remains stable or falls. Compared to its own history, Colchester’s assessment of the prospective real yield on offer in the local currency debt space is particularly attractive at this juncture.

Colchester Global warns that this article should not be considered a recommendation or investment advice. For more information and disclaimers, you can visit the following link.

Five Charts Explaining Investment Opportunities in European Private Credit

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The 99% of European companies have revenues below €10 million. Among large companies (those with revenues over €100 million), 96% are not publicly traded. According to Aramide Ogunlana, Head of Private Credit Investments at M&G, there is “a clear imbalance in funding sources,” providing additional data: only 4% of companies turn to private markets for financing, compared to 52% that issue bonds and 44% that are publicly traded. Ogunlana delivered a workshop during the recent European Media Day organized by M&G Investments in London.

Private markets have become a cornerstone of M&G Investments’ growth strategy in recent years. The firm is developing new vehicles to make these investments accessible to a broader range of investors. M&G has been investing in private credit since 1997, and its investment portfolio includes both liquid and illiquid corporate debt assets, amounting to €15 billion in private corporate credit and €35 billion in private debt as a broader asset class, including various strategies such as structured credit and real estate debt.

Ogunlana emphasizes the crucial importance of having a long investment history in these markets, as they are heavily relationship-driven: “Maintaining contact is very important, especially when aiming for the most illiquid parts of the market and acting as a sole lender. It’s also important to build relationships in the market to reach the companies you want to enter.” She also highlights the importance of having sufficient analytical capacity in-house to develop proprietary ratings. At M&G, the rating assignment process is conducted independently from the managers’ activities to ensure a neutral perspective. The firm focuses on segments rated B and BB and typically deals with over 200 liquid private companies and between 40 and 60 illiquid private companies.

Why Now?

According to Ogunlana, now is a particularly exciting time to delve into investment opportunities in the private debt market, noting the downward trend in the number of IPOs—the current levels are half of those recorded in the previous 20 years—along with the increase in delistings by companies wanting to return to private status to work more closely and flexibly with their funding sources (see chart).

The investment head notes that the potential is high, given that currently, 70% of European companies still finance themselves via traditional bank loans, compared to 22% of US companies. “This opportunity stands out particularly in Europe, although the global trend still points to high bank intermediation,” the expert notes. She adds that, historically, the European private credit market has outperformed the US in terms of returns (see chart).

As a result, the firm notes that new capital structures have emerged in recent years, and they also anticipate an increase in capital allocations to these market segments. Specifically, based on a survey conducted by Preqin in November 2023, they expect a 51% increase in private debt allocations (up from the current 9%), followed by a 32% increase in infrastructure and a 28% increase in private equity. The only category expected to see a reduction in allocations is hedge funds, which would drop from the current 23% to 19% (see chart).

According to similar data from a Cerulli study, the preferred vehicle for accessing these assets in the wholesale channel is ELTIFs and semi-liquid open-ended funds (37% and 36%, respectively), while co-investment is the least demanded option, with 12% of responses.

Misconceptions

Ogunlana also addressed a second set of perceptions that do not align with the reality of the size, liquidity, and returns currently offered by European markets. For example, she explained that, contrary to the perception that the high yield market is larger and more liquid than other private market segments, the reality in Europe is different (see chart).

Ogunlana demonstrates that the leveraged loan and floating rate note (FRN) market is worth €470 billion, compared to €350 billion for European high yield. “Seniority is very important for investing in these markets; we focus on finding the highest quality assets, at the top of the capital structure, and are very selective in our credit analysis because interest rates are still very high, so we need to calculate the principal recovery well,” she clarifies. She indicates that the recovery rate for syndicated loans is 73%, compared to 67% for senior secured debt.

The most illiquid part of the market is direct lending, with a size of €220 billion. This market is frequented by smaller companies (with EBITDA between €5 million and €75 million) and often each company has only one or very few financiers. It’s a market where “there is no room for error; we need a lot of investment analysis, and therefore our stance is very conservative,” the expert points out.

As a result of all these observations, the expert advocates for a review of the 60/40 model portfolio, noting that private credit offers diversification and decorrelation benefits compared to public markets. For example, Ogunlana states that direct lending behaves “almost like cash,” especially compared to high yield. Additionally, these assets offer a premium for complexity and illiquidity compared to other assets. For all these reasons, it would make sense for private markets to be considered not only as a distinct asset class when designing portfolios but also as part of the mix in more conventional fixed income and equity allocations (see chart).

The Return of Wealth Growth to 4.2% Offsets the 2022 Slump

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The global wealth growth rebounded in 2023 from the 3% contraction experienced the previous year, largely attributed to the monetary impact of the strong dollar. According to the latest UBS Global Wealth Report, wealth increased by 4.2% in 2023, making up for the losses of 2022 in both U.S. dollars and local currencies. This recovery was driven by growth in Europe, the Middle East, and Africa (EMEA), which saw a 4.8% increase, and the Asia-Pacific (APAC) region, which grew by 4.4%. With inflation slowing down, real growth outpaced nominal growth in 2023, with inflation-adjusted global wealth rising by nearly 8.4%.

The report highlights that wealth growth continues progressively worldwide, though at varying speeds. Since 2008, the proportion of individuals with the lowest wealth levels has decreased, while those with higher wealth levels have increased. The percentage of adults with wealth below $10,000 nearly halved from 2000 to 2023, with most moving up to the broader $10,000 to $100,000 range, which more than doubled. It is now three times more likely for wealth to exceed one million dollars.

On the other hand, the report explains that while inequality has been increasing over the years in rapidly growing markets, it has decreased in several mature developed economies. Globally, the number of adults in the lowest wealth bracket is experiencing a steady decline, while all other wealth brackets are consistently expanding.

Regional Wealth Insights

As the report indicates, this wealth recovery is driven by Europe, the Middle East, and Africa. According to the document, notably, while the global wealth decline in 2022 was mainly caused by the strength of the US dollar, last year wealth recovered above 2021 levels, even when measured in local currencies.

It is highlighted that since 2008, wealth has grown faster in the Asia-Pacific region, apparently driven by debt. “In this region, wealth has grown the most – nearly 177% – since we published our first Global Wealth Report fifteen years ago. The Americas are in second place, with nearly 146%, while EMEA lags far behind with just 44%. The exceptional growth in Asia-Pacific wealth, both financial and non-financial, has notably been accompanied by a significant increase in debt. Total debt in this region has grown more than 192% since 2008 – more than twenty times that in EMEA and more than four times that in the Americas,” they note.

In the case of the United States, it remains one of the few markets where wealth growth has accelerated since 2010 compared to the previous decade. In the US, as well as in the UK, wealth has grown uniformly across all wealth categories. “Our analysis shows that wealth inequality has slightly decreased in the US since 2008; in 2023, it housed the largest number of US dollar millionaires,” they add.

Regarding Latin America, growth was strong, but inequality remains present. Specifically, average wealth per adult in Brazil has grown by more than 375% since the 2008 financial crisis, when measured in local currency. This is more than double the growth of Mexico, at just over 150%, and more than mainland China’s 366%. However, Brazil has the third highest rate of wealth inequality in our sample of 56 countries, behind Russia and South Africa.

Finally, EMEA enjoys the highest wealth per adult in US dollar terms, with just over $166,000, followed by APAC, with just over $156,000, and the Americas, with $146,000. “Growth in average wealth per adult since 2008, expressed in dollars, shows a different picture: EMEA ranks last with 41%, compared to 110% in the Americas and 122% in APAC,” they explain.

Wealth Transfer and Horizontal Mobility

One of the key trends highlighted in the report is that wealth mobility is more likely to be upward than downward. “Our analysis of household wealth over the past 30 years shows that a substantial portion of people in our sample markets move between wealth brackets throughout their lives. In every wealth band and over any time horizon, people are consistently more likely to move up the wealth scale than down. In fact, our analysis shows that approximately one in three people move to a higher wealth band over the course of a decade. And, although extreme moves up and down the scale are uncommon, they are not unknown. Even leaps from the bottom to the top are a reality for a portion of the population. However, the likelihood of becoming wealthier tends to decrease over time. Our analysis shows that the longer it takes adults to appreciably gain wealth, the slower their increase tends to be in future years,” the report states.

In this regard, UBS has detected that “a large horizontal wealth transfer is underway.” According to the document, in many couples, one spouse is younger than the other, and generally, women outlive men by just over four years on average, regardless of the average life expectancy of a given region. This means that intra-generational inheritance often occurs before inter-generational wealth transfer.

“As our analysis shows, the inheriting spouse can be expected to retain this wealth for an average of four years before passing it to the next generation. Our analysis also shows that $83.5 trillion of wealth will be transferred in the next 20-25 years. We estimate that $9 trillion of this amount will be transferred horizontally between spouses, mostly in the Americas. More than 10% of the total $83.5 trillion is likely to be transferred to the next generation by women,” the report concludes.

Millionaires

Another relevant conclusion is that the number of millionaires is set to continue growing. In 2023, millionaires already represented 1.5% of the adult population analyzed by UBS. Specifically, the United States had the highest number, with nearly 22 million people (or 38% of the total), while mainland China was in second place with just over six million, roughly double the number in the United Kingdom, which ranked third.

“By 2028, the number of adults with wealth of more than one million dollars will have increased in 52 of the 56 markets in our sample, according to our estimates. In at least one market, Taiwan, this increase could reach 50%. Two notable exceptions are expected: the United Kingdom and the Netherlands,” the report concludes.