Investment Strategy Brief:                          The Case for Fixed Income in 2024

Below is a transcript of this week’s video.

Hi, this is Mike Reynolds with Investment Strategy at Glenmede.

Last week was a bit more eventful than usual for this time of year, as the frequency of major market catalysts tends to die down heading into the holiday season. On the surface, the Federal Open Market Committee’s December meeting seemed to fit that bill, as it decided against raising rates for the third straight meeting last week. This wasn’t much of a surprise to markets that were overwhelmingly expecting this outcome. However, the latest update to the dot plot projections, which show where the members see interest rates going over the next few years, seemed to set the stage for incrementally easier Fed policy next year. The median respondent now sees three rate cuts as the base case in 2024, down from one cut expected from the last publication in September. Markets rallied on this news but, pretty importantly, this would still put fed funds on path to remain above neutral through 2025, keeping policy tight for the foreseeable future.

10-year Treasury yields fell below 4% in the wake of this release, when just a few weeks ago they were bumping up against the 5% mark. That still puts yields squarely within a range that’s consistent with pre-‘08/’09 financial crisis levels. The bigger picture is that interest rates have put the extremes of the pandemic-era, and perhaps even the post-crisis era, in the rearview mirror. The practical implication is that there is now a credible cost of capital again for the U.S. economy and businesses.

What it took to get here was a pretty turbulent period for fixed income markets. Rising yields led to large losses in existing bonds that have been forced to mark-to-market against higher prevailing rates. The result? Over the last three calendar years, U.S. investment grade bonds have put together their worst run of performance in nearly a century.

The flip side to this rising yield environment is that it now sets up bonds for more normal returns going forward. The U.S. Treasury yield curve now sits well above the low during the COVID-19 pandemic, and it even sits at levels either at or above 20-year averages. In addition, Glenmede’s proprietary Global Expected Returns Model sees most of the Treasury curve either at fair value or at a slight discount to fair value, even after the rally in rates toward the end of last week.

As with most investment decisions, gauging the attractiveness of asset classes is a relative game, and bonds are once again a competitive choice for investors. Both bonds and cash are yielding considerably more now than they have on average over the past 20 years. The fair valuations observed in bonds stands in stark contrast to the premium valuations in equities (particularly large cap equities, where earnings yields sit notably lower than average). This makes bonds now appear more attractive on both an absolute and relative basis. In addition, the risk of recession remains elevated heading into the new year, a situation where bonds have historically helped diversify downside in risk assets. These two combined continue to make the case for tilts in portfolios in favor of fixed income due to the valuation disparities and economic sensitivity.

So to summarize, it was dovish news from the Fed last week, which reset expectations for rate cuts in the new year, but importantly are projected to keep rates in tight territory for at least the next two years. Yields fell on the news, but they generally remain consistent with levels before the Great Financial Crisis and what could be described as a credible cost of capital for the economy and businesses. Rising yields meant a difficult environment for buy-and-hold bond investors over the last few years, but that sets up a better starting point for more normal returns going forward. The upshot is bonds now appear fairly valued, which stands in contrast to equities that continue to trade at premium valuations. That valuation disparity, as well as the outstanding recession risks that could lead to downside in risk assets, make the case for investors to tilt portfolios in favor of fixed income at this time.

Thanks for listening! And please don’t hesitate to reach out with any questions.