- Investment Director
Iceland, Institutional
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Welcome to May’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 and excess returns in May, as disinflation, cyclical leads and employment data put central bank rate cuts back in focus. Substantial divergence in monetary policy led to diverging government bonds yields across the major developed economies, while spread sectors generally outperformed.
- Disinflation — one of the main themes driving market performance since the start of this year — has slowed and even stopped in some regions. After the significant rates sell-off in April, we saw mixed signals from economies in May. Cyclical leads in the US are pointing to a slowdown, with consumption moderating alongside a gradual uptick in the unemployment rate; on the other hand, inflation in the euro area increased to 2.6% from 2.4%, proving once again that the last stretch towards 2% will be the hardest in policymakers’ fight with inflation. In Japan, household inflation expectations remain elevated, and policymakers’ confidence grew that inflation is back in the system.
- US Treasury yields fell as the economy remained resilient and markets continued to push back the timing of the first rate cut. Meanwhile, the European Central Bank guided heavily towards a June rate cut, as euro-area growth and inflation continued to deviate from the US. Yields rose in Japan, as policymakers grappled with the gradual exit of extraordinary monetary policy, and a depreciating yen added further pressure for a June hike. In the UK, with core inflation remaining stubbornly high and a general election announced for 4 July, the first rate cut is now not expected until December.
What are we watching?
- Geopolitical risk remains front and centre, with prolonged conflicts in the Middle East and Ukraine. Iranian President Ebrahim Raisi was killed in a helicopter crash, the cause of which is still unknown. Because the Supreme Leader, Ali Khamenei, wields the most power, this event is unlikely to meaningfully shift Iran’s foreign or domestic policies. But it creates additional uncertainty regarding the succession of power following Khamenei. In Ukraine, there appears to be tacit approval for the armed forces to conduct limited strikes into Russian territory using Western materials for counterfire purposes to protect the city of Kharkiv.
- Shipping rates are drifting upward again as the peak shipping season starts. While we don’t expect rates to move as high as they did at the height of the pandemic, increased spot rates could translate into higher goods prices, adding further inflationary pressure to the global economy.
- European elections remain a potential source of market volatility. The outcome of the European Parliament elections could have significant implications for policy in the euro area for years to come. While the centrist coalition is widely expected to remain (with a smaller majority), we expect a shift to the right, potentially bringing Eurosceptic groups into the governing coalition. This could be negative for the process of EU integration (including significant joint bond issuance) and the green agenda. Within individual countries, a Le Pen outperformance could hamper French President Emmanuel Macron’s ability to reduce the French budget deficit, further bringing into focus fiscal deterioration.
- Is inflation turning upwards? As noted above, disinflation has slowed in many countries, and in some (notably the euro area), inflation has started to accelerate. However, commodity prices remain volatile: for example, the cost of a barrel of Brent crude oil fluctuated from US$77 in early January to US$91 in early April, returning to the low US$80s in May. Investors are increasingly looking at core inflation for signs of an imminent rate-cutting cycle, as this metric excludes the notoriously volatile energy and food components. Core inflation looks to be plateauing at high levels, driven in particular by services inflation and stubborn wage growth, with unemployment only very marginally increasing in many countries. If core inflation stays high, this tells us that financial conditions are not, in fact, tight and we may need to continue waiting before we see a sustained rate-cutting cycle.
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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