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Europe and the Middle East
Fixed Income Investment Outlook
Last Mile for Tightening
Central banks are finding it hard to finish the long journey toward inflation normalization, but we believe that policy rates are likely at or near their peaks—and could be maintained at elevated levels for some time. In an environment of slowing growth, restrictive monetary policy and rising idiosyncratic risk, we favor shorter durations, quality and a focus on security selection.
With roughly 500 basis points of rate hikes in the rearview mirror, the Federal Reserve has enjoyed significant progress in curbing U.S. inflation, which has fallen from a headline peak of over 9% last year to 4% in May. Goods prices have fallen, housing is turning the corner and even services seem ready to ease. However, core inflation has been stuck at the same level of around 5% for four months, and doubt is creeping into policymakers’ optimism that they can gradually tame rising prices.
Indeed, developed market central banks have recently taken a more hawkish tone. In surprise moves, both Australia and Canada increased interest rates by 25 basis points in June and the U.K. continued its hiking process with a 50bps increase. Although the Fed paused its tightening, its policymakers raised their terminal estimates and Chair Jerome Powell seemed to suggest that two more increases could be in store this year. The European Central Bank, meanwhile, hiked rates as expected, but its forecasts for its terminal rate came in higher, suggesting that more work needs to be done.
Despite ongoing disinflation, short-term price trends are keeping central banks “on the front foot” as they seek to drive inflation back toward target levels. That said, the overall policy environment remains fairly stable, and we believe that market rates are unlikely to change significantly for a while. Ten-year U.S. and European government yields are both at roughly the middle of their trading range for the year, while shorter maturities are at the higher end of that range. If anything, the current hawkish tone may freeze yields in the near term or increase them modestly until the cumulative effects of tightening further impact inflation trends and ease pressure on central bankers. Overall, we continue to believe that inflation will recede this year and next, possibly reaching close to target levels by the end of 2024.
In terms of positioning, we are emphasizing shorter duration in a “higher-for-longer” rate environment, although we would favor adding duration should yields move higher from here. Like government bonds, credit and securitized debt continue to be range-bound, while mortgage-backed securities may hold particular appeal at these levels. Overall, investment grade and high yield spreads have tightened somewhat, but increased dispersion is opening the door to select opportunity, which would expand should spreads widen somewhat. Given the already mature central bank cycles in emerging markets, the coming end of Fed tightening and relatively stable economic fundamentals, we continue to see value in emerging markets debt.
We provide details on our investment themes in the pages that follow.
1. Inflation Should Continue to Decline
Despite hawkish messaging from central banks, inflation has generally been coming in as expected—slightly weaker for headline numbers but stable for core inflation. In May, for example, U.S. CPI was 0.1% month over month and 4% year over year, while core inflation was 0.4% on a monthly basis and 5.3% versus last year. Within the core components, goods were up by a robust 0.6% MoM on strong used car prices while services increased 0.4% MoM. Still, we believe that inflation will slowly step down over the remainder of the year. Gains in core goods have largely been on the back of large increases in used car and truck prices, which should prove transitory. Meanwhile, shelter prices are already cooling and should continue to normalize despite a stabilizing housing market. Finally, as the labor market eases to more typical levels of balance, core services prices (excluding shelter) should remain at current levels or move slightly lower. All told, we project that headline and core CPI will end 2023 at 3% MoM and 4% YoY, respectively. Looking into 2024, we believe both headline and core inflation could end the year between 2% and 2.5%—within reach of the Fed’s target.
In Europe, inflation is also showing progress, with headline figures dropping to 6.1% YoY in May and core inflation easing to 5.3%. However, ECB inflation projections remain relatively robust, with the central bank anticipating core inflation of 5.1% this year and 3% in 2024 (vs. an estimated 4.7% and 2.5%, respectively, in March). Energy and food prices remain an issue tied to a tight labor market and increased unit labor costs. Still, at the ECB’s last meeting, President Christine Lagarde did mention small signs of softening inflationary pressures, even as overall trends remain too high.