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The US’s unexpectedly high growth rate in 2023 has investors watching to see if the US Federal Reserve (Fed) will keep interest rates higher for longer, as investment experts have said that expectations of a cut should be “dialled down”.
This delay will likely have an effect on fixed income investment returns for institutional investors through 2024. But what exactly will it do and what is causing it?
“This presents a significant opportunity for asset managers with strong fixed-income capabilities and performance."
In December, a Cerulli report said more were taking advantage of the recent strength. It said that institutional investors (68%) indicated that they would take advantage of higher interest rates and increase their allocations to public fixed-income investments. “Almost three-quarters of institutional investors (70%) expect to increase their allocations to actively managed fixed-income strategies over the next 24 months.”
“This presents a significant opportunity for asset managers with strong fixed-income capabilities and performance,” said Chris Swansey, Senior Analyst at Cerulli.
Higher than expected job creation numbers and pressure to appear apolitical during an election campaign will add to a complicated equation of high growth and sticky inflation for the Fed, impacting whether they start making cuts or not.
Total nonfarm payroll employment rose by 353,000 in January, said the Bureau of Labor Statistics, and the unemployment rate remained at 3.7%. Job gains occurred in professional and business services, health care, retail trade, and social assistance. Employment declined in the mining, quarrying, and oil and gas extraction industries.
Also showing positive news was the US’s real GDP, which increased at an annual rate of 3.3% in Q4 2023, up 2.8% compared to the previous quarter, according to the "advance" estimate from the Bureau of Economic Analysis. In the third quarter, real GDP increased 4.9%. The increase in the fourth quarter primarily reflected increases in consumer spending and exports.
Imports, which are a subtraction in the calculation of GDP, also increased, said the Bureau.
“Defying pessimistic forecasts, US economic growth has progressed at a significant pace over the course of 2023."
“The US Economy defied expectations in 2023. Many forecasters predicted a recession at the year’s outset, some even asserting it with a 100% probability,” said the White House’s official statement on the growth rate in December 2023. Despite the positive tone of the message, the implications on inflation were still likely a concern for the White House.
“Defying pessimistic forecasts, US economic growth has progressed at a significant pace over the course of 2023. Last December, the private consensus for real economic growth as measured by the Blue Chip Economic Forecast was negative 0.1% for the year,” it said.
The White House added that the latest Blue Chip projection for 2023 growth, which incorporates all available data to date, is positive 2.6%, driven by strength in consumer spending, a revival in manufacturing structures investment and increased state and local government purchases.
With the US economy so strong it’s likely that inflation will stay slightly elevated, which would be the leading cause of the Fed not cutting rates.
“In the face of the most aggressive rate hiking cycle witnessed in a generation, markets have grappled with a regional banking crisis, soaring energy costs, a persistently strong dollar, and geopolitical uncertainty,” said Lisa Hornby, Head of US Multi-Sector Fixed Income at Schroders Global.
Hornby said that this economic strength can be attributed to two primary factors, one being the drawdown of consumer excess savings accumulated during the Covid-19 crisis, which has rapidly diminished from its peak of $2 trillion. “Secondly, the implementation in 2022 of federal investment programmes, namely the CHIPS and Science Act (approximately $280 billion) and the somewhat ironically named Inflation Reduction Act ($781 billion),” she said.
But with these factors now already established, what trends will continue into Q2 2024?
This means that there is an increasingly complicated picture of high interest rates and their effects on portfolios for insurers, especially given the little political will to see any economic slowdown.
As mentioned, the US inflation rate remains above target, which is partly what has driven the reluctance to cut rates. However, it does look likely that there will be a reduction to around 2%-2.5% at some point this year, said Columbia Threadneedle in its latest outlook report. “Overly restrictive monetary policy is probably, therefore, no longer warranted. The market is pricing in 1.5% worth of cuts this calendar year, which translates to an unusually large number of cuts given a soft landing is the current consensus forecast.”
Columbia added that it’s likely that the Fed will avoid making headlines during the presidential election.
“This [economic] strength is pushing back the expectations of up to five interest rate cuts by the Fed discounted by the market."
“This will make achieving the 1.5% of cuts this year very difficult. One route would be to front load the easing, however, with inflation still 1.4% above target it would be a brave Fed that starts with a 0.5% cut in March,” it said. “Normally, against the backdrop of a still growing US economy, monetary policy poised to loosen and inflation on the way down we would be expecting strong returns from equities and fixed income. However, given prevailing valuations we are a little more circumspect. If the US does manage to avoid a recession then we expect decent, rather than exceptional, returns from equities, but still above-normal returns from government debt.”
Others also highlighted that strong economic performance means strong job performance, which is another key factor that feeds into the health of fixed income returns. “This [economic] strength is pushing back the expectations of up to five interest rate cuts by the Fed discounted by the market,” said Javier de Berenguer, Investment Manager and Fund Selector at MAPFRE Gestión Patrimonial.
He said that because of the relative strength of the US economy, hopes for lower rates should be dialled down. He also noted that employment data was solid, with more than nine million job vacancies open. “The labour market is heating up even more, which in itself is a very strong argument for not lowering rates," he said.
Continued high interest rates have had a substantial impact on a fixed income portfolio because as interest rates increase, bond prices decrease. When interest rates rise, new bonds are issued with higher yields, making existing bonds with lower yields less attractive to investors.
It is important to note that not all fixed income securities are equally affected by rising interest rates.
The stagnant fixed income market, described recently as undergoing a dry spell by a senior figure in the market, has seen a turn to emerging markets debt and private assets.
It is likely that the current trends will continue until rates start to decrease. This means that many will have to continue their path toward locating new sources of yield, at least for now. Especially as, when it does bounce back, Cerulli said that 68% of institutional investors it surveyed indicated that they would take advantage of higher interest rates and increase their allocations to public fixed-income investments – meaning a crowded field could be expected.
Nevertheless, a rate cut is still likely. More of the US’s leading trading partners are struggling to keep growth positive, and the UK officially fell into recession this week, with market sentiment indicating that a rate cut would be essential to keep the US from going in the same direction.
It just might not come within the next few months. ING said it saw signs that the Fed may miss the March opportunity, but noted that further on in the year a cut would be more likely. Others have said they are looking toward July.
