- Investment Director
Switzerland, Institutional
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Welcome to June’s 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
- Most fixed income sectors generated positive total returns in June as global Treasury yields declined following signs of cooling economic growth and rising geopolitical uncertainty in Europe. Spread sectors generally underperformed government bonds but achieved positive total returns.
- The European Central Bank delivered its widely telegraphed rate cut but fell short of committing to further easing. The Swiss National Bank also cut rates by 25 basis points (bps), and the Bank of England and US Federal Reserve (Fed) are expected to join the rate-cutting party in August and September, respectively. However, higher-than-expected inflation data in Canada, which came on the heels of a 25 bps rate cut by the central bank, potentially cautions the rest of the world against declaring victory on inflation too early.
- While the far right made gains in the European Parliament’s June elections, the existing coalition was confirmed, albeit with a smaller majority. The biggest fallout was in France, where President Emmanuel Macron called snap elections, hoping to regain momentum for his centrist coalition. The spread between French and German bonds widened significantly and stayed high throughout June, before compressing partially in early July, as markets priced a decreasing probability of an outright majority for Marine Le Pen’s Rassemblement National party. Perhaps more striking was the reaction in credit markets, where spread widening completely reversed in a matter of weeks, seemingly shrugging off heightened political risk.
What are we watching?
- Political risk. The lack of political clarity resulting from the French election, along with Hungary holding the rotating EU presidency, could hamper Europe’s effectiveness at a critical time when European Commission leadership is reshuffling after the European Parliament elections. The UK election in early July produced a change in government, with the Labour Party winning with a significant majority. The election result is not inconsequential, especially if there is no functioning opposition: when faced with the inevitable choice between cutting spending or raising taxes, the incoming government is likely to choose neither and opt to loosen fiscal rules. This could boost short-term growth, but also raise inflation in the medium term. Meanwhile, November’s US election is coming more sharply into focus. After the most recent debate between presidential candidates Trump and Biden, there was a notable sell-off and steepening of the US Treasury yield curve as well as a widening of inflation breakevens. In the coming months, we expect to see additional volatility as polls start pointing markets towards the potential impact of changes to trade, tariff, tax and regulatory policy.
- Japanese policy decisions. Following the news that one of Japan’s largest banks, Norinchukin, will be liquidating over US$60 billion of international fixed income securities in the coming year, the issue of Japanese financial stability has come to the fore. Given the ample liquidity of the Japanese government’s US-dollar holdings and the ability of global central banks to initiate FX swap lines, we are unlikely to see a repeat of the US-dollar funding crisis of 2011. However, I am watching this space carefully because:
- Tighter US monetary policy has impacted portions of the Japanese banking and financial system, causing losses and weakening balance sheets.
- If the Bank of Japan (BOJ) accelerates policy normalisation in response to higher and more sustained inflation, policymakers will need to incentivise firms to return overseas profits to Japan and domestic institutions to keep investing in the bond market.
- Tighter Fed policy and still-loose BOJ policy continue to put downward pressure on the Japanese yen, forcing the Ministry of Finance to intervene to stabilise the currency.
- Emerging markets. As we move further into the 2024 election cycle, the focus remains on political stability and governance in emerging as well as developed markets. The first quarter brought the first leadership change in over a decade to Indonesia, while the second quarter saw underperformance relative to expectations from incumbents in India and South Africa. In India, Narendra Modi’s Bharatiya Janata Party remains a dominant political force but had to form a coalition government for the first time in a decade, potentially limiting parliament’s ability to implement reforms. A similar story unfolded in South Africa, where the African National Congress remains the largest party in parliament but lost the parliamentary majority it had held since 1994.
Where are the opportunities?
- Given how drawn out and uncertain the rate cycle has been, we continue to see opportunities in higher-quality total return strategies that are less constrained by benchmarks. This could include global sovereign and currency strategies or unconstrained strategies that are able to navigate the late cycle by allocating across different sectors.
- In our view, core fixed income, and particularly credit, strategies are looking increasingly attractive. Higher-quality fixed income is appealing from both an income and capital protection perspective, with the income from these strategies not only attractive outright but also providing an additional buffer to rate volatility.
- We think high-yield and emerging markets debt still offer potential, but we expect continued volatility given how late we are in the cycle and the normalising of default rates relative to current spreads. However, the robust carry may make high yield a good equity substitute. For all higher-yielding credit, including high yield, bank loans and convertible debt, we advocate an “up-in-quality” issuer bias in case the slowing economy undershoots a soft-landing scenario, and defaults and downgrades accelerate.
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