Key points for 2024
We are sailing through particularly troubled waters at the moment, with economic pitfalls but also major geopolitical whirlwinds, between the war in Ukraine, unrest in the Middle East and tensions between China and Taiwan. On top of this, there are important electoral deadlines this year, not only the US presidential election, but also elections in the European Union, Taiwan, Russia and India.
Naturally, the decisions of the major central banks (Fed, ECB and BoJ) will also have a major influence on the markets. Although interest rate rises now seems to be behind us, rates are likely to remain at a high level for some time to come. If inflation remains high, unemployment will be the determining factor in central bank policy.
Another critical factor is the high level of corporate and government debt. In the USA, the budget deficit exceeds 5% of GDP and the debt-to-GDP ratio has reached a record 99%, compared with 91% in 2020. The question of how to refinance this debt will therefore become acute from 2024 onwards. Between 2024 and 2026, some USD 800 billion of corporate debt will have to be refinanced worldwide.
The major question is therefore the future direction of the inflation and unemployment curves. Experts are expecting price rises to fall to around 3% in the USA in 2024. Unemployment figures will therefore be at the centre of investors‘ concerns, as they will determine whether we are heading for a soft landing for the economy or a recession. If unemployment starts to soar in the US, this could lead to a rate cut by the Fed. However, if the unemployment rate remains below 4.5% and inflationary pressures ease towards the 2% target, rate cuts should remain limited.
Our scenario
As far as we are concerned, we are forecasting a scenario of weak growth and falling inflation, and we should not see a recession similar to that of 2008, but rather a simple contraction in the economy. Growth in the US economy should remain positive, at around 1%, while in Europe the slowdown could be greater, with growth limited to 0.3%. China, for its part, is facing numerous structural problems and is struggling to achieve its 5% growth target. In contrast, the Japanese economy is expected to be positive, which will profoundly change the situation in that country.
We remain positive on the global economy, however, as the themes of AI, energy transition and infrastructure will be supportive factors, especially as we cannot rule out a few positive surprises, such as a possible end to the war in Ukraine or a solution in the Middle East, or even an easing of tensions between China and the United States.
The main challenges ahead
While there are reasons for optimism, investors will face a number of challenges in 2024:
- Interest rates. After the rises of 2023, we can expect rates to return to the downside next year as inflation falls back towards 2%. The question will be whether this happens in late 2024 or early 2025.
- Soft landing. The Fed is trying to achieve a soft landing for the economy and avoid a recession, but unemployment will be the determining factor.
- US elections. The US elections will be the focus of market attention, as they will determine global geopolitical developments.
- Eurozone and UK. Europe will be the critical region in 2024, as there is a real risk of recession. Energy prices remain high and the effects of the war in Ukraine are being felt more strongly.
- Japan. Japan is abandoning its policy of controlling the yield curve and may put an end to negative interest rates. However, this will only be done very gradually so as not to slow down the economy, notably by increasing debt costs.
- Geopolitical tensions. It is difficult to know how long the war in Ukraine and the hostilities between Israel and Hamas will continue. Finally, the evolution of tensions between the USA and China remains a major question mark.
- China. The property sector, which accounts for 20% of GDP, is impacting the financial markets and the country is facing major structural problems. For the time being, the authorities do not seem to want to launch a massive budget support plan. China faces a risk of deflation, which is something to keep an eye on before deciding to return to the country.
How is our portfolio positioned?
For the record, our aim is to optimise the natural convexity of ‚pure vanilla‘ convertible bonds by creating a ‚convexity brick‘ that is predictable and transparent for investors.
Accordingly, our strategy is based on the following 5 pillars:
- Pure Vanilla & Convexity. We invest exclusively in „pure vanilla“ convertible bonds, i.e. with no options, credit or equity derivatives. Currency exposure is fully hedged. The aim is to generate capital appreciation through convexity. This enables the maximum performance of the equity component or the maximum performance of the bond component to be achieved at maturity. This strategy is particularly attractive in periods of uncertainty such as the present.
- No benchmark and global approach. The fund does not track an index and invests worldwide, without regional or sectoral constraints. This ensures good diversification and optimises convexity.
- Good credit quality. On average, our portfolio is Investment Grade, which optimises the convexity profile and reduces risk.
- Priority: capital preservation and liquidity
Convertible bonds make a comeback
After a catastrophic 2022 for convertible bonds, due to an accumulation of negative factors (rising rates, widening spreads, falling equities and a lack of decorrelation between asset classes), the situation is now much more favourable for this asset class:
- Very active primary market. Rising interest rates have prompted many companies to turn to convertible bonds to reduce their financing costs. The market is therefore very active worldwide, particularly in Japan, Europe and the technology, clean energy and infrastructure sectors in the USA.
- Attractive entry point. The asset class is currently trading at a discount to its theoretical value.
- Limited risk: Convertible bonds offer an attractive alternative for gaining exposure to equity market performance, with a lower risk budget than a direct equity investment.
- Positive yield. Coupons and yields are now positive and investors are „paid to wait“ for the equity markets to rise again, which means that they do not „time“ the market and are always invested.
- Return of mergers & acquisitions activity.
All the planets seem to be aligned for a revival of the convertible bond asset class. Today, the financial conditions are right: the potential for interest rates to fall, tighter corporate credit spreads, resilient equity markets and a strong likelihood of increased equity market volatility in the years ahead.
The correlation between equities and interest rates has reached its highest level for 20 years. The last time we reached such a level was during the period 1996-2001. This was an exceptional period for the convertible bond asset class! During that period, and under conditions similar to the ones we have today, US convertible bonds outperformed the US equity markets. We believe we are entering a similar period.