- Investment Director
Switzerland, Intermediary
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Welcome to November’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
- Bond market moves revolved around US election news, with Donald Trump returning as US president from January and the Republicans gaining control of Congress and winning a slim majority in the House of Representatives. After a post-election rise in yields, fixed income markets rebounded to generate positive total returns, with market participants generally welcoming Trump’s key cabinet appointments.
- The US Federal Reserve and Bank of England both delivered rate cuts, despite continued above-trend growth. Although US year-over-year inflation data was higher than expected, the market still anticipates more than three 25 bps US rate cuts between now and the end of 2025. In the UK, with easing credit conditions, accelerating nominal growth and unemployment at multi-decade lows, the Bank of England may be forced to lower the number of rate cuts it expects to deliver in the next year.
- Following the collapse of the German coalition government and the ousting of the French government, the euro area faces a period of significant uncertainty, in which its ability to respond to likely US tariffs may be limited or delayed, potentially undermining an economic cycle that is starting to visibly lag other regions. Markets are already pricing in downside risk to growth forecasts, with European bonds rallying much more than US and UK equivalents in November.
What are we watching?
- Trade policy. Trump’s fiscal, immigration and tariff policies are likely to cause higher near-term inflation and higher inflation volatility. Based on the lack of engagement with inflation breakevens, the market appears to assume that the tariff threats are a bargaining chip. In the very near term, a significant rise in trade and higher orders from firms are possible before tariffs are introduced.
- Reciprocal tariffs and other measures. Any retaliatory tariffs or an all-out trade war could also increase inflation and lead to tighter monetary policy, with negative implications for growth. China is the main target of the US tariffs, but the two countries are less directly intertwined than in the past, with 15% of China’s exports going to the US today compared to 22% in 2016. Emerging markets, meanwhile, account for two-thirds of China’s exports. If China continues to shift exports to non-US developed markets, other countries could impose tariffs in an attempt to protect higher-value products (notably autos), where China has recently built significant infrastructure and capacity.
- France. Political gridlock and fiscal slippage are likely to continue after Michel Barnier’s technocratic government was voted out after attempting to pass an “austerity” budget to bring the deficit down to 5%. The spread between French and German bonds stands at a decade high while, remarkably, the spread with peripheral European bonds such as Spain’s has now turned positive. Investors appear to believe that the European Central Bank (ECB) can step in to inject markets with liquidity or deliver rate cuts to support the economic cycle. But if structurally loose fiscal policy feeds into higher inflation, it could make it difficult for the ECB to intervene meaningfully. In such a scenario, European bond yields could move higher, and the euro could depreciate.
- Credit spreads. Despite going through an extended period of interest-rate volatility, credit spreads have continued to tighten thanks to strong private corporate and consumer balance sheets. Valuations in the US are now at 15-year tights, while political concerns cloud the outlook for European credit, where political fragmentation could drive spreads wider. Expected flows from investors exiting money market funds provide a supportive technical backdrop, as does the emergence of yield-motivated buyers. However, macro volatility could lead to spread volatility, requiring an agile approach to make the most of the opportunities in credit investing.
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. These strategies could also enable investors to allocate capital away from cash and reduce reinvestment risk without taking on significant duration or credit risk.
- 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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