Episode 89: A look ahead to 2024—addressing your unanswered questions (part 2)


After patiently waiting for many months, signs that our fixed income outlook may be coming to fruition emerged at the end of last year. But what can we expect in 2024?

In part 2 of our podcast episode, we focus on answering your frequently asked questions on fixed income. Are inflation risks behind us? Where are yields going? Are central banks done with their rate hikes?

For all this and more, tune in to our new podcast episode.  

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Kevin Headland:

Commentary is for general information purposes only. Clients should seek professional advice for their particular situation.

Macan Nia:

At that point, central banks were still in the thoughts of tightening three or four more times in the first half of this year. Do you believe that's going to be an environment at any point this year? I don't think so.

Kevin Headland:

Welcome back to Investments Unplugged. This is part two of our frequently asked questions 2024 outlook. Again, I am your co-host, Kevin Headland, and with me again is my other co-host, Macan Nia. Welcome back, Macan.

Macan Nia:

Good to be back, Kev.

Kevin Headland:

A whole part two. It's like we recorded part one yesterday.

Macan Nia:

Well, we did.

Kevin Headland:

I know. I'm kidding. Anyway, as we ended off yesterday or last part one, we ended up with the US elections and equities and of course not surprising, we want to start with fixed income for part two, natural progression from equities to fixed income, where we think the opportunities in fixed income, last year of course was a year of patience for fixing investors for 10 months, almost 11 months. The fixing opportunity was not working out the way we expected it to. And then lo and behold, the calendar year turns to November and December and the 10-year treasury yield moves materially from almost 5% to almost 3 1/2. So very strong returns there for fixed income.

Now, as of the start of the year just like equities, we're seeing a bit of change in direction and yields are back up a little bit, but we do believe that fixed income still looks attractive, shall we say, for 2024. I think there's still a lot of opportunity there, but first I think we have to talk about whether the risks are behind us. And the risks of inflation, we talked about already we think inflation is to downside, but where are yields going? Have the central banks ended their rate hike cycles? Have the long end of the yield curve peaked? And Macan, you did some research on peak yields.

Macan Nia:

Yeah, and we've talked about this actually on previous podcasts and I think it's important just to revisit it. So we saw the lows, it seems so long ago, the lows in the US 10-year and the summer of 2020 of .5, Kev, that seems so long ago, and since then we've been marching higher. And we believe anyways that we've likely peaked in this current cycle and the peak would've been around 5% and we saw it in mid-October. And what we did is we looked back at previous tightening cycles and we try to glean whether there is some relationship between whether when the Fed peaks or when the Fed stops raising rates and whether it can give us any visibility in terms of yields peaking.

And we looked at the previous six tightening cycles in the US since the 1980s and of the six, four of the six, Kev, the 10-year peaks roughly three months before the last Fed hike. In one of the six, it basically peaks simultaneously and then the other example, the 10-year peaked roughly one month after the last Fed hike. Taking it all together when you look at the previous six, I think we're comfortable saying that if you believe that the Fed has stopped, that yields typically peak two to three months or a quarter around that date. So we believe that they may have peaked or they may have stopped and if they go, they may go one more time, although that's not what we envision, but yields have likely peaked.

So that high that we saw a 5% is likely the high in the current cycle, unless there's, like you said, some unexpected increase in inflation then we could trend up that way, but we don't see that. So as of today, the US 10-year is around 4%. And our team believes is okay, we could still trend lower for yield. So that price appreciation opportunity is still evident. There's no reason to believe why we couldn't be in that basically. Depends, Kev, it depends on what type of or slowdown you expect. So the slowdown we expect right now your guard of variety recession not too severe.

We could keep trending towards three, and you know momentum, Kev, if our target is 3 1/4, yeah, we could hit three based on momentum and algos and all that, but it's not hard to envision where there still could be anywhere between 50 to 100 beeps more of downside for the 10-year. Now it's not going to be in a linear fashion, but that's where that price appreciation comes from in addition to the yield that you're getting. On the 10-year, for example, today is four, so you get four plus another four to five, that's how you get your mid to high single digit returns for 2024.

Kevin Headland:

Yeah, I think it's key there as well. You said the Federal Reserve and bank can have both likely stopped raising rates. The market's actually pricing in about 5 1/2 rate cuts for the full year of 2024 for both the Federal Reserve and the Bank of Canada. So definitely no rate hikes in the pipeline expected. Of course there's always surprises as we know that could lead that way, but again, when we talked about the balance of risks, and I think that's where Kim's down to, the balance of risks are to a declining rate environment, a declining yield environment, which again would be positive for fixed income and positive for bonds.

And this is where when we look at our three phased approach to fixed income which we talked about for ad nauseum for the last 14 months, I'd say, this is where that second phase, the embrace duration does come into play. And it's important to understand where you're embracing duration as well across the yield curve in the US and Canada or perhaps even externally where yields in other foreign countries are even better or higher. And central banks have already started cutting rates in a lot of other countries. So you can actually benefit by going globally and looking outside just in North America for your yield opportunity. We were asking if patients will pay off. I think it has already to some degree and I think it's important to make sure that we're still seeing the opportunities.

You say mid-high single digits in fixed income, those are extremely strong returns. These are where balanced funds tend to do well. Equities are up, fixing them is up, you're reducing your volatility. And I think it's a key is where despite the material drop in fixed income, and I got to correct myself, I just checked, US 10-year yields hit a bottom of about 3.8 and not 3.5 at the end of last year. Now they're at 4% let's say. That means there's still room to run for the downside and that means that the fixing opportunity is not over. The duration play is not over. But it's important again to embrace active management and fixed income as we've been saying for quite some time and perhaps look elsewhere than just North America. You expand your options to elsewhere to drive overall total returns because opportunities look very attractive in fixing them globally, not just in the US or Canada.

Macan Nia:

And you mentioned credit, right, Kev? So credit did very well last year.

Kevin Headland:

Yeah, especially high yield. Yeah.

Macan Nia:

Especially high yield. And that was on the backdrop of a resilient economy. We saw that play out in the first 9, 10 months. Corporate balance sheets have been resilient. That narrative may face some challenges in 2024. As the global economy, the US economy slows credit there's going to be a difference in credit, right? Not all credits going to be treated equally within those bans. There's going to be companies that can weather the storm, others that cannot.

And I just think that when it comes to insecurity selection is always important, but when you get these tides, the tide raises all the boats, that tide may not be as powerful for credit this year as it was last year. So security selection within credit in a slowing economy, joblessness rates come or unemployment rate, joblessness, unemployment rates increasing. So I think it's very important to not look at last year's performance in bonds specifically in high yield and extrapolate that forward because I think the backdrop is going to be different this year.

Kevin Headland:

Well, look at high yield, the spreads are incredibly tight. We're looking at 3 1/2% high yield spreads on the index. And we started the year at 2023 roughly around... Sorry. We're roughly just around four or so. But listen, you've received a lot of benefit from spread compression in high yield and already higher yields how much lower, how much time can spreads go especially as you said, in a weaker economic environment or at least a slowdown? We've done this before, we've ranked percentile spreads or spreads on a percentile basis for both high yield and IG across their history, right now the percentile ranking for high yield spreads are roughly the 16th percentile. Now as the percentile goes lower, that means they're tighter than average.

Typically, you want to be investing in high yield when the spreads are greater than average because that means there's more room for tightening which is where you generate the strong price return. So clearly when you're talking about momentum, momentum has been on the favor or in favor of high yield spreads. How much higher can they go? Where's the benefit? Are you getting paid to take on that risk? And that's where we think, again, as you said, perhaps this is where you don't want to be taking on this risk in high yield corporate credit, you want to perhaps go to, again, longer duration, more conservative, government bonds where the yields are still attractive and you have the benefit perhaps of some duration mathematics behind you to generate better outsized returns because high yield has done so well, especially over the last 12 months.

Macan Nia:

Yeah, and I think you just mentioned it too, right, Kev, the asymmetric opportunity in bonds today compared to really even despite the move that we've seen in the last couple of months, and we were pounding the table on this Kev, this would've been in... When would've been? October of last year? Where we were pounding the table saying, okay, the way that yields had moved there you were kind of favored to take on duration risk because the upside versus the downside was favorable at that point. And even despite the move that we've seen recently it's maybe not as attractive from asymmetric value, but it's still favorable for bond investors.

Kevin Headland:

Talk about that just for a second here. So I just ran the mathematics today. So out of the 10-year treasury yield, the upside returns is when yields fall, of course. So if yields fall 50 basis points from where they're today through the full year, so where we're today in 2025, so call it the beginning of next year.

Macan Nia:

So let's say the 10-year goes from four to 3 1/2 roughly.

Kevin Headland:

Right. Over the course of the full year. Your total return is roughly 7.6% on the 10-year treasury yield. If it goes up 50 base points, so again, a negative impact, your return is .5%. So now you've got to decide where the likelihood of hitting 3 1/2% over the course of the full next year or going up to 4 1/2%. I would again believe that it's likely more to 3 1/2% the probabilities are there versus 4 1/2%.

Let's look at even longer duration. Look at 20-year US treasury, your 50 base points drop in a 20-year treasury yield gets you a 10 1/2% return over the next one year or a downside of 1.6%. So you talk about the asymmetric risk there it's still present, but perhaps now we're talking about a 50 base point move instead of 100 base point move, but even then you're still in your upper single digit returns very easily and you just get back, you said 3 1/2% we were there middle of summer last year. I can see that happening especially in this weaker economic environment in 2024.

Macan Nia:

Kev, let's go back to the 10-year and let's just think. Let's say yields spike back up to the highs that we saw in mid-October of 5%. So for the 10-year treasury, if that was to happen, let's say yields go from 4% to five, you're down roughly 3% because you had that cushion of your yield. Now if we go from four to three it's 12%. So, again, talking about the balance of risk, look what was happening in October of last year, right? We had just gone through a period of stronger than expected economic growth. At that point central banks were still in the thoughts of tightening three or four more times in the first half of this year. Do you believe that's going to be an environment at any point this year? I don't think so.

I don't think we go back to the economic growth environment that we saw end of summer, and I don't think we go back to where we're raising rates. So the balance of risks still favor bond investors and we still think that the party was a little late to start. All year we were waiting and waiting and waiting and then boom, November, December it came quickly. And like we said in yesterday's podcast, depending on which fixed income indices you went from zero flat to up 6 1/2%. So these moves can happen quickly and very similar to equities we all see those charts. We've put them out ourselves. If you miss the best X days or the worst days, how much different your return is? That's even put on steroids when it comes to the fixed income market because our return profile is lower.

Kevin Headland:

It's so magnified and you can see if anything, the most recent history of fixed income upside and downside shows you how quickly the moves can happen. And to miss out on that is unfortunate. At the same time, the party started and it was a great bash towards to the end of the year, but even with the change into the new year does not mean the party's over and everyone's gone home. I think it's important that you realize the party's still going. It might not be as lively, but it's still probably going to be a good time if the yields play out the way we think. And you think about best case, worst case scenario. Best case you get your yield, nothing happens, best case again, 100 basis point move, great returns, worst case, unlikely to happen of our 100 basis point jump.

And your downside, as you said, is minimal anyway. So when you look at that, your risk scenarios, we still see fixed income is very, very attractive for 2024. Now let's jump to another risk perhaps that might even cause a spike in yields or whatnot. And we talked about US elections in part one is a potential risk, but what about the geopolitics? It's becoming more and more evident or at least in headlines talking about geopolitics. This tends to be one of your favorite subjects, Macan. What about the risk of geopolitics affecting the markets this year or any given year?

Macan Nia:

I think the easy answer is, and the honest answer is it doesn't matter historically. When you look at previous conflicts, they do have impacts around the actual incident, but very rarely when you look past three, six months has it still had that impact. Look at the Russian-Ukraine conflict, right? A great example. Initial total drawdown of 3%, but you had recovered that in two weeks. The most recent one in basically what's unfolding in Palestine. You recovered that initial 5% drop in five days. So historically they're very short, they don't have a long-lasting. I think the bigger things when it comes to geopolitics that we are changing our view on is when it comes to global warming, now people that's a very sensitive topic.

I think from a basis, I think Kev, where we come from it and look at the anecdotal evidence is it's not that the weather is getting hotter, it's just leading to extreme changes, whether it's cold or warm. And I think where this can impact inflation is a great example, it's impacts on crops. That seems to be a much bigger issue over the last couple of years. When it comes to weather too, how many last year based on weather events where you stuck in your home whether there was a flooding or whether there was a wildfire? That has impact on economic activity. So I think that's where it may have more long-lasting, but it's too hard to, Kev, incorporate that into our models and our return expectations.

It's just something to be aware of. And I think that's something where we put the responsibility on our portfolio managers to look at the businesses and see whether these changes and whether are having an impact on their bottom line. I think the thing when it comes to geopolitics we're seeing at the margin today, what's unfolding in the Middle East is it's having impact on oil prices. It could have impact on shipping. What's happening in Yemen, the Houthis are basically targeting shipping routes, that will have an impact on the short term.

But Kev it's hard for me to envision again that it will have a longer lasting impact. The Americans are sending two battleships in there, that's going to be dispelled very quickly. But that's something to be mindful of. Despite our equities views and we're optimistic is we're still very mindful that there are downside risk in the short term to geopolitics, but if you do get a selloff, Kev, based on geopolitics, we will be the first ones adding back to equities based on that.

Kevin Headland:

I think it's key is saying this idea of disruptive not destructive, looking at how climate change impacts individual companies.

Macan Nia:

Kev, can I stop you there? Explain the disruptive versus destructive mentality when it comes to these type of events.

Kevin Headland:

I think disruptive is a short term, as you said, volatility markets, headline risk, you get the market moves, the whip saws, but in terms of destructive means it's not long-lasting in terms of leading to a material bear market or leading to a material bull market perhaps either way, whether it's positive or negative. And I think that's a key is that ultimately, the markets move longer term on the fundamentals and rational investors. And you said if there's a sell off based on esoteric facts or impacts, you end up getting buyers coming in because they realize that the value of the business is overall, not the price, but the value is not destroyed by this event.

Now definitely some companies are impacted more than others, and this is why I was going to say is, when our investment managers look at an investment, wherever it is, you can identify, okay, maybe I should be investing in perhaps a company that ships things through the various straits because of maybe short term. There's uncertainty there. You can identify the risks of a company and how they're impacted by certain climate change. So where are they farming? What type of investments or what kind of products do they have? So identifying those more on a case by case basis is I think more important than making general statements that this will impact the overall markets for a prolonged period of time.

And I think make sure you're aware of that, but at the same time, we'd still believe in the overall landscape when we look at the fundamentals and you add, again, these potential esoteric short-term risks, this is where it just makes sense to have more of perhaps a conservative or defensive approach to near-term investments against why our illustrated portfolio remains at 50-50, is there still is some short-term pockets of uncertainty and we need to be aware of that.

Macan Nia:

Yeah. But ultimately, Kev, when you look at, we talked about election years and how great the returns are nearly up 75% of the time, average return since I think it's like 10%. Because let's put our pragmatic hats on, does a sitting president want to get in? Yes. Do they realize that they'll get in with a better economy, less geopolitical risk? Of course. Are they going to try to put in policy to make sure that happens? Yes. So maybe this is my optimistic hat. I think if things unfortunately were to get worse in that part of the world, I think [inaudible 00:22:41] will prevail because it's not in anybody's interest for the most part that this becomes worse.

Kevin Headland:

I agree 100%. The issue is that markets don't tend to be rational especially in the near term, right? I think Warren Buffett said in the near term markets are a voting machine, in the long term they're a weighing machine. And I think the problem is that that volatility can also spook some investors. And it's important to understand that investors are aware of these near term headline risks that any given day the S&P 500 it's a 50% chance whether they're up or down, it's a coin flip on any given day, but you're invested longer, you have a higher probability of being positive and that's got to be the focus, not in the headlines the short-term risks, the day-to-day operations, nobody's investing, or not nobody, but the investors looking for their RSPs or retirement or whatnot should not be investing on a day-to-day basis. Absolutely. Because again, it's a coin flip where they're up or down.

Macan Nia:

Yeah. Most time horizons are actually longer than 10 years. We know when volatility hits that timeframe becomes a lot shorter, but Kev, you said on any given day it's a coin flip. It's 50-50. On any given month it's basically 60-40, but even as small as an increase of three years, it goes from basically 60% to 90-10. So investing is a probability based decision and in any three year rolling period over the last 50 years you have been up nearly 90% of the time. I'm going to take those odds every day.

Kevin Headland:

100%. Those are great odds in your favor. The last question we want to talk about tends to be one that comes up and often it comes up because our clients are hearing comments from other firms or whatnot or perhaps there's a change in mentality or viewpoint and it's about the Loonie, the Canadian dollar, and where the Canadian dollar may or may not end up or at least direction of where it's going. And especially coming into this year where there's a lot of talk that the Bank of Canada is likely going to be more aggressive in rate cuts than the Federal Reserve in this dislocation of central bank policies, weaker oil prices coming down from 85 to $70 and perhaps there was risk that was going lower, that's all downward pressure on the Canadian dollar.

However, when you think at oil prices perhaps where they are at 70 odd dollars today we think the balance of risk is the upside, maybe not materially, but still the upside risk, especially you said the conflict in the Middle East and that should create some perhaps risk in supply and the price should go higher. So that's an expectation there. And now we're also seeing the Federal Reserve the expectations have changed and now Bank of Canada Federal Reserve rate policy or rate cuts is pretty much even so that again puts less downside pressure on the Canadian dollar. And we've seen the Canadian dollar rally slightly. It was actually positive for the full year of 2023 when you look at it versus the US dollar-

Macan Nia:

Which is crazy to think, Kev.

Kevin Headland:

Yeah. It's quite interesting.

Macan Nia:

If we asked the question given everything that happened with oil last year and what happened with Central Bank policy would you have ever thought that the CAD would be up 2 1/2% versus the USD?

Kevin Headland:

No, not at all. And I think a lot of focus tends to be just on the USD and relative to other currencies perhaps, not necessarily against the CAD, and the Canadian dollar we've stood quite well. Ultimately, where it goes from here is we think pretty much a narrow channel. If we're at right now at the 72 cents, or sorry, 75 cents, excuse me, not $72 of oil, 75 cents Canadian dollar versus US dollar roughly, it's probably going to be this now trading range plus or minus two cents, maybe upside migrates towards 76, 77 cents which tends to be our high end of our fair value range, but definitely we don't see material risks to the downside in the Canadian dollar, I think which is important to understand again where those risks lie and we don't think the material to the downside nor do we think their material to the upside as well. Probably very now trading range in the near term.

Macan Nia:

Yep, exactly.

Kevin Headland:

All right. I think that concludes our frequently asked questions. If there are advisors out there that have additional questions, please reach out to your investment management wholesaler, we'd love to answer them and perhaps even add them to future podcasts. So please, if you have questions feel free to reach out. Macan, you had something to bring up, last word.

Macan Nia:

Yeah, so yesterday we went through our views in the terms of the illustrated portfolio with equities. I just have one question, Kev, let's just say the average return last year was 6 1/2% for bonds, are you taking the over or the under to that for 2024 returns?

Kevin Headland:

From where we're today I'm thinking we take the over because I don't see the downside risks that we saw earlier last year. And we think about that 6 1/2% that came in two months and where we're today I think there's upside, but not materially more upside, but also more upside to or against positioning. I think you want to be positioned in higher quality, longer duration.

There's still risks in high yield. If we do get a slowdown, if we do get some more downside risk to the economy there's some risks that exist in the spreads and that could be negative returns. So it's about being mindful not just in fixing them, but equities as well. We're overall positive, but you got to be in the right areas of investments to generate those positive returns. And it's important, I think in quality is likely the name for at least the first six months of the year.

Macan Nia:

Yeah, I think you said it well. When you look at these bond indices in aggregate likely to do better than what they did last year, but underneath the hood there is definitely, depending on the credit scale you're looking at, high yield versus AAA, things of that nature, that's where I think there'll be much bigger disparities relative to last year.

Kevin Headland:

Yeah. If you asked me the question, do you think high yield's going to outperform or underperform last year's returns? I would say probably underperform. Yeah.

Macan Nia:

Oh, underperform. Yeah, because what would have to happen? You'd have to get a re-acceleration in the US economy because when we talk high yields predominantly US, like you said, what was it? You said basically yields have only been tighter in high yield only 15% of the time in history. So that's crazy, right? You need something you would need re-acceleration of the US economy without an acceleration in inflation to get even spreads to compressed tighter and that just does not seem like a best case today.

Kevin Headland:

Coming back down I keep saying balance of risk probabilities, you talk about probabilities. If something has only been more attractive 15% of the time in history, going back to the late '80s, are probabilities in your favor? I would say no. It's possible, but not probable. And I think probabilities are key, especially when we're investments. We want the odds to be in our favor, and I think that's important to understand that, yeah, there's always the possibility, but again, going for the probability makes more sense overall.

Macan Nia:

Exactly.

Kevin Headland:

Let's close it off there.

Macan Nia:

Perfect.

Kevin Headland:

Thank you very much for listening. For those listeners that enjoy our podcast, please rate us. It helps like-minded investors or like-minded podcast listeners find us on the different podcast players. And again, if you have any comments or questions, please reach out. We love incorporating your comments into future podcasts. So thanks so much for listening once again for Investments Unplugged, this has been Kevin Headland.

Macan Nia:

And Macan Nia.

Kevin Headland:

Have a good one. Take care. This podcast is provided as a general source of information and should not be considered personal, legal, accounting, tax, or investment advice, or construed as an endorsement or recommendation of any entity or security discussed. Investors should seek the advice of professionals prior to implementing any changes to their investment. Certain statements in this podcast are forward-looking that are predictive in nature, depend upon or refer to future events or conditions. Forward-looking statements are subject to risks, uncertainties, and assumptions that could cause actual results to differ materially from those set forth.

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Kevin Headland, CIM

Kevin Headland, CIM, 

Co-Chief Investment Strategist

Manulife Investment Management

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Macan Nia, CFA

Macan Nia, CFA, 

Co-Chief Investment Strategist

Manulife Investment Management

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