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The US Federal Reserve is preparing to pivot from its latest round of tightening. The central bank announced in its March meeting that it was raising interest rates by a quarter of a percentage point and that further decisions would be made on a meeting-by-meeting basis. As we approach a potential shift in policy, Fidelity’s investment teams have taken a closer look at the performance of three European asset classes following the Fed’s previous hiking cycles.
Our analysis focuses on the months before and the months after the Fed’s final hike in the cycles of 2000, 2006, and 2018 - the most recent cycles for which we have a sufficient depth of data to review. Over these periods, returns in the European investment grade bond market remained relatively stable, returning an average of 6.8 per cent 18 months after the pivot. Over the three cycles, the market returned a maximum of 13 per cent and a minimum of 2.8 per cent, resulting in a range of returns of 10.2 percentage points.
In contrast, the European high-yield bond market has been less predictable in those same timeframes with the range of returns a remarkable 30.9 percentage points. Although the performance of the high-yield market was particularly disappointing following the 2000 pivot, prompting a string of defaults and potentially skewing the data, the maximum return reported 18 months after a final Fed hike was still only 5.7 per cent.
Fidelity’s research shows a steadier performance in the European leveraged loan market. Even taking into account the hit on returns because of the pandemic 15 months after the 2018 hike, the range for this asset class was just 2.9 percentage points 18 months after the pivots - suggesting a more stable performance when compared to the other two asset classes.
The data most likely reflects the inherent lack of interest rate sensitivity in the floating rate loan product as well as the stickiness of demand from collateralised loan obligations (CLOs), which make up the majority of the European buying base. CLOs are less likely to be forced sellers, and can provide an important anchor for the market to soften price falls.
Similarly, for investors seeking safety in products with a longer duration and higher credit quality at the end of a hiking cycle, the loan product’s defensive focus has proved of interest. The market is dominated by names from the telecommunications, business services, mission critical tech, and healthcare markets - sectors that typically offer recurring revenues and strong cash generation across the cycle. The senior secured nature of the product has in the past also proved attractive as a credit diversifier.
Past performance is no indication of future returns, and the current economic backdrop differs greatly to previous hiking cycles. Not only is the ongoing liquidity squeeze in the banking sector weighing on the Fed, but deglobalisation, political uncertainty, and the transition to a net zero economy all provide their own challenges. There’s a risk that short-term cyclical pressures such as tight labour markets, combined with long-term structural shifts of near-shoring and the energy transition, will keep underlying inflation high and sticky. The relative predictability that low-duration credit products have shown in the past will give investors food for thought as they plot their way through the cycle.