In a world where economic growth is slowing, the outlook for fixed income, particularly credit, has turned more positive when compared with equities.

Equities, as an asset class, tend to perform well when the economy is experiencing robust growth, when PE ratios and multiples are expanding.

“Today, we are seeing more of a low but positive GDP environment over the next couple of years, which really is very well suited to, particularly credit, but all of fixed income,” says Jack Stephenson, fixed income specialist at AXA Investment Managers, in an interview with The Asset. “We are starting to see signs of the economy slowing down. We see that through the labour market. We see that through the slowing consumer demand, and inflation is continuing to moderate as a result of pulling back in the consumer and less demand for goods and services.”

Traditionally, companies that issue investment-grade or high-yield bonds don’t really need strong economic growth in order to perform well.

Their businesses can perform well even in an environment where economic growth is slowing, and the bonds they issue can also perform well.

In fixed income, credit is a collective term for investment-grade or high-yield bonds issued by corporates. A high-yield bond offers a high rate of interest because of its high risk of default and has a lower credit rating than government bonds or investment-grade corporate bonds, but the higher interest income or yield makes it more attractive to investors.

“These companies just need enough economic growth so that they can continue to grow revenues and grow even Ebitda (earnings before interest, taxes, depreciation, and amortization) but without the super strong growth that equity needs, the type of strong growth that can create inflation, higher interest rates and problems for companies,” Stephenson says.

As long as the economy does not slip into a recession that would adversely impact bond issuers, the outlook for credit, as an asset class, will remain positive.

“So where we think we're headed, particularly for credit, is that there will be a low but positive GDP environment, which is why I think the outlook is quite positive for credit, whereas for equities, there are still some headwinds, I think, it’s simply related to slowing growth that we see around the world,” Stephenson says.

Nevertheless, Stephenson argues that it is important for investors to have a diversified portfolio with a balance of different risks across bonds and equities.

“That's because the types of risk that you get in equities are clearly very different to the ones that you get in fixed income, and the kinds of environments in which they are less or more likely to outperform can complement each other quite well through a cycle. Fixed income can play many different roles within investors’ portfolios. And then over the more short-term outlook, what we see today from an economic standpoint is very well suited to fixed income because of the pain that we've had to get through today, and also because of the outlook that is very well suited to credit,” he says.

Two investment themes

In a separate interview with The Asset, Owen Murfin, investment officer and institutional portfolio manager at MFS Investment Management, argues that while bond markets are fairly priced at present, it may not be pricing in a potential deceleration in economic activity or possible geopolitical risk in the second half of 2024.

For fixed-income investors, there are two themes: investing in bonds with longer maturities and holding on to more cash with the intention of investing it in higher-quality assets.

“The two themes are to continue to be supportive towards duration in your portfolio, so that would mean longer than benchmark. Or alternatively, you're holding a lot of cash in portfolios to consider extending the maturity of the cash into more high maturity bonds and combining that with some high-quality carry assets,” Murfin says.

Murfin argues that the risk for high-yield fixed income is that there may be recession that would result in defaults.

“We feel that generally high yield has done too well for our liking, and it's really pricing in with very high confidence and a sort of soft landing scenario, which might be hard for the Fed to engineer, particularly if inflation is sticky. So I don't think you're really compensated for going down in quality in fixed income, necessarily,” he says.

The US Federal Reserve is widely expected to cut interest rates at least twice this year, with the first rate cut speculated to take place in its next meeting on September 17-18 2024. However, this will depend on whether the inflation rate has slowed down to its targeted level. The US inflation rate is at 3.3% as of end-May 2024, well above the Fed’s target of 2%.