Diverging fortunes: unearthing US opportunities

We examine how the theme of divergence is creating opportunities for global bond investors in the US market.

Key themes

• We are seeing global bond investment opportunities arising from the concept of divergence.
• The negative impact of the Ukraine conflict is coming through in terms of weaker growth and higher energy and food prices, especially in Europe.
• The US is significantly more self-sufficient in energy and food than Europe so there are likely to be some US beneficiaries of higher energy and food prices.
• The gap between US and European interest rates should stay wide over the near and medium term.
• We believe there are opportunities to start building exposure to three-year US Treasuries and to US investment-grade credit securities.

As bond investors with a global remit, a lot of the themes currently interesting to us are heavily influenced by the concept of divergence as different areas of the world take different approaches to monetary and fiscal policy to deal with their respective economies.

We have just been through a period where policy looked similar in most places. Following the global financial crisis, most central banks converged towards a zero level of interest rates, and this has involved various forms of quantitative easing (QE) which effectively dampened down yields across the curve.

Diverging responses

Now though, we are moving in the opposite direction, and responses to the various concerns about inflation and the economy are coming through in different ways. Since the Covid crisis we have seen a lot more fiscal stimulus in addition to monetary intervention, and the contrast in policy between the US and European economies has become quite marked.

Europe has taken a more ‘socialist’ approach to supporting struggling sectors than the US; in particular, with the Ukraine conflict contributing to an energy and food crisis as the world recovers from the pandemic, European governments are providing subsidies to those sectors and individuals struggling with higher energy and food costs.

While higher prices are likely to have a negative impact on growth in Europe, the US finds itself in quite a different position. It is significantly more self-sufficient in energy and food than Europe so there are likely to be a number of US beneficiaries of higher prices.

As a result, the US economy is in stronger shape: US consumers were already in a good position because of the wealth effect that has been filtering through from a reduction in debt and increasing saving levels, while the US corporate sector is also in a stronger position than its European counterparts.

Different responses, different time horizons

We are seeing this reality play out through differing central-bank policy decisions. The US Federal Reserve (Fed) is looking to raise rates rapidly because it needs to choke off inflation expectations, whereas the European Central Bank (ECB) is expected to take a more measured approach, as it is starting from a much lower base and, in some cases, negative interest rates. At the same time, the Fed is also quickly reducing its balance sheet, either by not reinvesting sale proceeds or ultimately through selling bonds back into the market – another form of monetary tightening. In Europe we are seeing a little of this, but at nowhere near the same speed or magnitude as in the US.

With governments fiscally stimulating in different ways and central banks operating in different ways, the net result is that bond and currency markets will respond differently over different time horizons. This means that the gap between US and European interest rates is likely to stay wide, as should the gap between US and Japanese interest rates, as Japan does not face the same inflationary pressures and thus the authorities are able to maintain a deflationary mindset.

As global bond investors, we believe these divergent trends offer some attractive opportunities. Divergence means that we can invest in one market, and perhaps short another to balance that risk in an environment that we expect to remain quite volatile for some time.

US rate rises already priced in

The opportunities in the US are coming from the idea that, because the Fed has been so vocal about the possibility of raising rates, the market has already priced that scenario in. Therefore, we are seeing opportunities to start building exposure to three-year US Treasuries and to US investment-grade credit securities where we can seek to gain additional yield from widened spreads on companies that we view as relatively safe in terms of their ability to service the coupon and pay the principal back. Buying those types of bonds and locking in that yield over the next two to three years seems an attractive option for flexible bond investors currently.

We can’t say the same in Europe where yields are not as attractive (having not risen as much). We expect this scenario to continue for some time, as the ECB gets into its stride in raising interest rates. On top of that, the negative impact of the Ukraine conflict is coming through in terms of weaker growth and higher energy and food prices. This is leading to less demand and less investment compared to what we are currently seeing in the US.

From a credit perspective, we therefore favour the US over Europe, where we believe companies will remain more challenged in terms of the overall cost of doing business over the next couple of years.

Authors

Paul Brain