- Investment Director
Switzerland, Institutional
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Welcome to the August edition of Bonds in Brief, our monthly assessment of risks and opportunities within bond markets for fixed income investors. Each month, we explore material macro changes and how best to navigate the latest risks and opportunities we see within bond markets.
Key points
- Fixed income markets generated positive total returns for a fourth consecutive month. High yield outperformed government bonds while investment-grade bonds were mixed. Declines in global government bond yields were driven by the US, where inflation and employment data provided the final piece of evidence for the US Federal Reserve (Fed) to cut rates in September. In his highly anticipated speech at the Jackson Hole annual economic symposium, Fed Chair Jerome Powell reiterated that “the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks”.
- Following the rally in July and August, the level of bond yields relative to cyclical risk assets looks rich. Bonds are pricing in a significant economic slowdown while risk assets are still holding up. Should there be signs of a lift in cyclical data, bond yields could retrace. Equally, should bond markets have correctly priced in global economic weakness, equity markets would need to adjust.
- In Europe, despite recent inflation data coming in higher than European Central Bank (ECB) expectations, policymakers still look likely to cut rates again in September, with growth leads implying downside risk to the ECB’s forecast for third-quarter growth. However, further cuts are likely to be gradual, given the potential for upside surprises in inflation in the next year. Meanwhile, the Bank of England has also shown a clear dovish bias, despite inflation proving sticky, an improving economic growth outlook, strong consumer spending and resilient household balance sheets.
What are we watching?
- Iranian retaliation against Israel for the deaths of senior leadership in Hezbollah and Hamas (as noted in last month’s Bonds in Brief) has started to take place, with hundreds of rockets fired by Hezbollah at targets in Israel. Israeli forces retaliated, striking targets in southern Lebanon. For now, both sides seem to signal that continued escalation would not occur, but the situation remains highly volatile.
- Japanese rates. Markets may be underappreciating further yen appreciation and the potential for rate hikes from their current level of +0.25%. As markets are pricing in policy rates of around 0.40% by July 2025, that would imply no rate hikes are expected until the second half of next year. However, with data suggesting inflation has sustainably returned and multiyear-high levels of Japanese consumer confidence, the current policy mix appears far too accommodative.
- US election uncertainty could contribute to bouts of market volatility in the coming weeks, as specific details on policy agendas are codified and betting odds shift between Kamala Harris and Donald Trump. Congressional races are also important, since the balance of power will determine whether certain proposals become law.
- German woes. There are increasing concerns that the remarkable display of unity that has characterised the euro-area policy response since the pandemic in 2020 may be coming to an end, as economic, fiscal and political challenges are coming to the fore. In a reversal of the early 2010s, German growth in real terms has significantly underperformed the rest of the bloc. This creates a headache for policymakers as, based on the Taylor Rule for setting monetary policy rates, rate cuts would be warranted if the ECB were setting policy for Germany alone whereas rate hikes would be warranted elsewhere in the euro area.
Where are the opportunities?
- Given how drawn out and uncertain the rate cycle has been, our key conviction remains a focus on higher-quality total return strategies that are less constrained by benchmarks. This could include global sovereign and currency strategies that have the potential to shine during these periods or unconstrained strategies that are able to navigate the late cycle by allocating across different sectors. The combination of a still highly unpredictable US election outcome and the significant uncertainty around economic policy only adds to our conviction in less constrained strategies.
- The tide has turned on rates and with cuts on the horizon, we see core fixed income, and particularly credit, strategies as increasingly attractive from both an income and capital protection perspective. Moreover, with the gradual cooling of inflation and slowing of the economy, higher-quality fixed income is likely to benefit from positive convexity (its price benefiting from lower yields). For European investors looking to protect themselves from ongoing volatility, high-quality income may offer an attractive avenue not just in local but also global markets.
- We think high-yield and emerging markets debt still offer potential, but advocate a cautious approach given how late we are in the cycle and the normalising of default rates relative to current spreads. At the same time, the robust additional income potential may make high yield a good equity substitute. However, for all higher-yielding credit — including high yield, bank loans and convertible debt — we believe an “up-in-quality” issuer bias is warranted in case the slowing economy undershoots a soft-landing scenario, and defaults and downgrades accelerate.
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