- Investment Director
United Kingdom, Institutional
Change
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Welcome to the April 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 negative total returns but positive excess returns in April as persistent inflation data led market participants to price a higher-for-longer policy rate backdrop. Credit continued to outperform government bonds.
- Global yields increased the most in a single month since September 2022, as strong data releases showed that economies (particularly the US) remained resilient and inflation continued to surprise on the upside. In response, markets pushed rate-cut expectations further out; the European Central Bank is now expected to cut in July at the earliest, the Bank of England in September and the US Federal Reserve (Fed) in December.
- Real US GDP is around 9% higher than it was pre-COVID, while the euro area and UK economies have only grown 3% and 1.5%, respectively. Yet most measures of inflation, wages and unemployment have shown similar trajectories, meaning the growth/inflation trade-off could be significantly worse in Europe because it has inflated as much as (or more than) the US for lower real economic growth. With the manufacturing cycle showing signs of an upturn and continued growth in services globally, local inflation dynamics should become more acute. In such a scenario, following what the Fed does may not lead to the best long-term outcomes outside the US.
What are we watching?
- Israel, Iran and Venezuela. Geopolitical tensions remain heightened in the Middle East, and events over the last month — including a strike on Israel from Iran and the ensuing retaliation — seem to confirm a regional conflict is now imminent. In Venezuela, a reversal of the détente between the US and the Maduro regime is underway, as the US is imposing a variety of sanctions on Venezuela’s energy industry. While a negative shock for commodity markets, this is not a repeat of the 1970s: in the decades since, there has been a reshuffling of energy production, and the US has emerged as the world’s largest oil producer.
- Deterioration of budget deficits. Over the past two years, 85% of developed economies have experienced fiscal slippage by deviating from their expected fiscal consolidation plan — on our calculation, by an average of 4.5% of GDP. These big deficits have occurred when booming nominal growth amid high inflation has boosted countries’ tax revenues. But governments have spent that inflation dividend — implying significantly deteriorating fiscal resilience. For now, markets appear relatively calm about fiscal risk, perhaps because of their focus on debt to GDP ratios, which have been much more benign than the deficit slippage would suggest. If term premia rise more appreciably or nominal GDP worsens, markets could take notice, causing a sell-off in bonds issued by highly indebted sovereigns. Deteriorating nominal GDP would have an immediately powerful impact as debt to GDP ratios worsen, whereas rising term premia would lift the average interest cost slowly given longer debt maturities.
- Stagflation. Undoubtedly one of the ugliest words in finance and one we don’t use lightly. Given that inflation is still running relatively hot while growth slowed more than expected during the first quarter, it is worth debating whether the US economy (among others) could soon find itself facing stagflation. While evidence of gradually cooling labour markets is a sign that policy rates could be eased, we are still closely monitoring the trend. Central banks may not be showing sufficient resolve in their inflation fight and will need to make difficult policy decisions down the road.
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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Brij Khurana