Bond markets have experienced a heightened level of volatility and recent drawdown having emerged from a period of exceptionally low yields. In the aftermath of the Global Financial Crisis (GFC) and the pandemic, policy makers tested zero and even negative yields in a bid to fight the low growth, low inflation environment with artificial and extraordinary central bank interventions.

Today, in a bid to fight the exact opposite, policy has again driven yields to new post GFC highs. Market participants now readily accept, for a variety of reasons including the great energy transition, 'friend-shoring' and geopolitics, that inflation and therefore yields are likely to be higher on average over the decade ahead. However, what perhaps is missing in this view is that cycles can still co-exist amongst these structural trends. The next year is one where we believe the cycle will come to the fore.

Macro themes in an uncertain future

The macro environment as we enter 2024 looks to be uncertain and uncomfortable future, and one in which things are likely to come to a head. Our central case sees a slow deflation of the excess demand meeting limited supply difficulties, but there are a myriad of risks. We believe the Reserve Bank of Australia (RBA) will be on hold through most of 2024, with a modest easing cycle commencing late Q3 next year. GDP growth will remain below trend, and weakness will progress from households through to the investment side of the economy. Finally, we think inflation will moderate back towards, but not quite reaching, the RBA's 2-3% target.

Strong population growth and housing dynamics risks further RBA tightening, but this is balanced against the pressures generated from the 4.25% tightening seen so far. Population growth should ease up to the pre-pandemic trend. We see the slowing economy leading to a slowly rising unemployment rate, which will move the economy back toward equilibrium. Downside risks come from slowing global growth, and China in particular. Geopolitical pressures are also being watched closely, as they have the potential to weigh on growth and push inflation higher. Locally, we watch for cracks in spending and the path of fiscal policy.

Markets on the other hand have toyed with the 'higher for longer' and 'policy likely to grip' themes. Today the market has very little priced in terms of an easing cycle, with an average cash rate over the next half decade of 4 to 5% and even a little higher over the subsequent 5 years. This, in our assessment, is unlikely to be validated by the RBA over time.

Meanwhile corporates are facing a more challenging environment after having enjoyed a couple of years of above-average profits buoyed by ultra cheap debt funding costs, an ability to pass through cost inflation and having benefited from strength in nominal revenues. In 2024, these very corporates are likely to face a constrained consumer, ongoing cost pressures and elevated refinancing costs. It will be a year of the haves and have nots in the corporate space; those with prudent balance sheet management in resilient industries separated from others exposed to consumer cyclical, interest rate sensitive industries. Investment grade companies for the most part remain well placed to weather an economic slowdown. Lower credit quality segments (and in particular leveraged companies, related to construction, housing, non-conforming asset backed securities and consumer finance) stand to be tested in the year ahead, at the very least with mark to market drawdowns but potentially with permanent loss of capital for investors.

With the cycle maturing, our preference is to be concentrated in higher quality credit which remains the sweet spot for investors with equity like return prospects. We remain wary of the more complex, levered or subordinated credit segments, especially those lower in quality. In seeking opportunities, we remain patient as we seek meaningful future high yield, loan and emerging market debts.

The road ahead

Looking to 2024, the fixed interest asset class provides a compelling proposition as a genuine diversifier with attractive yields offering strong competition to a number of growth asset classes; a privileged position following years of the opposite. However, the latter stages of the economic cycle will likely deliver higher levels of volatility, creating opportunities for those investors who have to tools, skills and risk taking heritage to be able to take advantage of.

In 2024, our 'north stars' remain that:

• Duration is becoming increasingly a better tool, albeit one that needs to be actively navigated
• Pockets of dislocations are to be expected late in the cycle, creating opportunities
• It is better to take larger positions in safer segments rather than simply pursue yield, and
• Opportunistic allocations to controversial segments such as senior debt of A-REITs, analysed, stressed for various scenarios and sized correctly have to potential to deliver outsized returns for investors.

Author: Jay Sivapalan, Head of Australian Fixed Interest, Shan Kwee, Porfolio Manager and Emma Lawson, Fixed Interest Strategist - Macroeconomics