- Investment Director
Switzerland, Institutional
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Welcome to September’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
- September was the fifth consecutive month of positive returns in fixed income markets amid further shifts towards global monetary policy accommodation. Spread compression across most credit sectors generated positive excess returns, particularly in high yield.
- The US Federal Reserve (Fed) delivered its long-anticipated rate cut. The 50 basis points cut and remarks from Chair Jerome Powell were viewed as moderately dovish and the Fed now appears to be shifting its focus from inflation to the labour side of its dual mandate.
- Senior policymakers in China announced a comprehensive range of monetary and fiscal support packages aimed at reviving the world’s second-largest economy. While the reaction was most noticeable in Chinese equities, Chinese government bond yields also moved sharply up, but have a long way to go to reverse their near-constant decline year to date.
- Stock/bond correlations have been normalising in recent weeks. While short rates are already pricing in aggressive policy easing, longer-term bond yields are still elevated compared to the levels seen since the global financial crisis. We expect stock/bond correlations to exhibit their traditional negative relationship going forward, now that inflation is closer to central banks’ 2% target.
What are we watching?
- Regional war appears to be nearly at the door in the Middle East. Following the killing of Hassan Nasrallah, the leader of Hezbollah, Iran launched ballistic missile strikes on Israel. While the strikes did not result in any fatalities (that might change as more information becomes available), Israel has stated that it will respond to the attack, most likely in the form of an invasion of Lebanon but the response could extend to strikes on infrastructure within Iran’s borders. A regional war, along with the substantial human cost, would have an immediate impact on global energy prices as well as global logistics. Oil prices have already begun to rise in response and inflation breakevens have widened.
- Policy rate cuts. There is a risk that central banks are cutting pre-emptively, potentially even prematurely, when it comes to inflation. They see their top priority as protecting against tail events but now they seem hyper-focused on avoiding a spike in unemployment. With the return of the growth/inflation trade-off, getting price increases sustainably back to the 2% target will likely require countries to generate below-trend growth and lead to job losses across economies. However, central banks are apparently unwilling to accept that trade-off. The implication is that most central banks now see their inflation targets as a floor rather than a long-term average. In this scenario, inflation could average closer to 3% over time as opposed to 2%, and that outcome isn’t priced into current inflation expectations. Central banks are seemingly prepared to take out insurance against any chance of recession and believe that cutting rates will ensure a “soft” landing. However, they are effectively making a claim that growth can slow around trend (and not below), with this being sufficient to bring inflation sustainably back to target. Should they be wrong, cutting rates now could extend the cycle, potentially causing inflation to reaccelerate and stay higher for longer.
- Germany. In September, three regional elections were held in Thuringia, Saxony and Brandenburg, together constituting around 10% of Germany’s population. The far-right party AfD made significant advances, winning in Thuringia and coming a close second in the other two regions. Combined with the far-left party BSW, the populist vote reached nearly 50%, which could prompt the governing coalition to toughen its stance on immigration, as well as law and order. The debt brake continues to constrain the government’s hand and there is no prospect of this being loosened before national elections are due in September 2025. At the margin, this should reduce the appetite for further European integration or common borrowing across the euro area.
- In France, where political stalemate continues, President Emmanuel Macron appointed Michel Barnier as prime minister. Forming a government will be a lengthy process despite far-right and far-left parties showing willingness to compromise on key legislation. The political paralysis comes at a particularly bad time for the French cycle, with the budget deficit continuing to rise and the latest composite purchasing managers’ index reading of 47.4 showing the economy is struggling to grow. The country’s weak debt dynamics are starting to concern international investors, who are now consistently pricing French sovereign debt in line with Spain’s. This makes the government’s challenge to bring public finances under control all the more difficult. The spread between the two countries’ sovereign yields turned negative for the first time in late September, meaning Spanish bonds commanded lower yields (and higher prices) than the French equivalent.
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 about less constrained strategies.
- The tide has turned on rates and 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. For all higher-yielding credit — including high yield, bank loans and convertible debt — we believe an “up-in-quality” issuer bias is warranted.
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Monthly Market Review — August 2024
A monthly update on equity, fixed income, currency, and commodity markets.
By
Brett Hinds
Jameson Dunn