- Investment Director
Portugal, Institutional
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Welcome to October ’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
- Fixed income markets had a challenging month, driven by higher government bond yields in most regions, although spread compression across most sectors provided some relief. Developed market sovereign yield curves have steepened in recent months amid monetary policy easing but markets are pricing a slower pace of cuts in some regions given continued economic resilience.
- In the UK, the headline measures in Chancellor Rachel Reeves’ 30 October Budget included large tax rises for businesses and wealthy individuals as well as significant investment commitments to increase real trend growth. While gilts sold off on the day, there was no obvious sign of market stress or liquidity strain. However, the increase in government spending and borrowing had been largely priced in by a sustained move higher in yields since the summer, with UK fixed income significantly underperforming other government bonds in October.
- Japanese elections delivered a shock outcome as the Liberal Democratic Party (LDP) failed to win enough seats for an outright majority in the Lower House elections. The LDP, and Prime Minister Shigeru Ishiba, will likely attempt to form a coalition government but in the meantime, major policy initiatives outside of monetary policy will likely either remain on hold or on autopilot.
What are we watching?
- Donald Trump’s victory in the US election could represent an enormous catalyst for bond markets to engage with higher yields, particularly on the longer end of the curve. This is because Trump’s policy proposals would represent a material negative supply shock — tariffs have the potential to reduce the global supply of tradeable goods and restrictive immigration limits available workers — increasing the probability of more sustained medium-term inflation. The bond market now expects additional inflation risk premia, which is showing up in wider inflation breakeven levels. Put in a global context, we’re seeing a reacceleration in the UK and, to a lesser extent, in Germany as well.
- What does a Trump presidency mean for Europe? Should the Trump administration follow through on policy proposals of 10% tariffs on European goods, this could entail a negative shock of 0.7% – 1.5% GDP for the euro area. In such a scenario, much of the negative growth shock could be absorbed by the European Central Bank in the form of aggressive rate cuts, especially as the fiscal response would likely be muted. The European Commission has only just reinstated its fiscal rules, France is in political gridlock and any decision making on a potential response to the US is unlikely to be decisive or quick.
- Geopolitical uncertainty continues, with the Israeli retaliatory strike against Iranian military facilities. Whether the Iranian government decides to strike back and keep the regional conflict going is an unknown at this point. As always, conflicts can rapidly get out of hand and global oil markets started the month at approximately US$68 per barrel, increased to US$77 and ended the month at US$69, indicative of the volatility that could be triggered in global markets, particularly if Iranian energy production was targeted.
- CMBS stress. Commercial real estate troubles persist, with some AAA-rated tranches once again experiencing losses. Higher rates in October took away some breathing room acquired earlier in 2024. While CMBS continues to be a sector with elevated risk, it also has upside potential as both fundamental and technical factors have improved.
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 significant uncertainty around economic policy in a Trump administration 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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