Key Points
- Higher and stickier inflation may persist for some time.
- Sovereign debt levels represent a key risk for many nations, and policymakers will need to tread carefully.
- Some economic signals suggest the likelihood of a US recession is increasing. We believe there is quite a high probability that the US Treasury market could see a sharp market correction within five years.
- We think that an active, unconstrained approach to fixed-income investing can help deliver sufficient yield and diversification against an uncertain macroeconomic backdrop.
With a familiar picture of rising public spending, loose fiscal discipline and anemic economic growth in many developed markets, we expect to see both shocks and opportunities ahead for global fixed-income investors.
The ‘regime change’ in the macroeconomic backdrop has seen quantitative easing and low interest rates give way to higher inflation. It also signifies the arrival of shorter, more violent and unpredictable business cycles. For us, these conditions show similarities to market conditions last seen in the 1970s.
Such a backdrop can complicate both strategies and timing decisions for investment managers, and we believe bond investors need to adopt a fresh, more unconstrained approach. Nevertheless, we do believe some attractive yield will be on offer for those whose strategies succeed.
Reshoring Efforts and Debt Challenges
Despite the recent success of central banks in targeting inflation, we believe the higher-for-longer inflation backdrop will endure for some time yet. We anticipate that financial markets will increasingly be called upon to fund both the reshoring of supply chains and rising national fiscal deficits.
During the pandemic, much of the private sector borrowed cheaply and extended the maturity profile of its debt. Many governments also borrowed, but, in some cases, did not extend the debt maturity profile at a time when interest rates were close to historic lows.
Sovereign debt burdens are now a key market talking point for many nations, in terms of the possible risks that may lie ahead. We have seen on a few occasions how market-driven events can quickly lead to major corrections in bond yields. We saw it in the eurozone sovereign debt crisis, and in other fiscal mishaps that have played out in the past. Our view is that policymakers will need to tread carefully in an environment where inflation is higher and stickier than witnessed over the last few decades.
US Risks
One country we believe fixed-income investors should watch closely is the US. Against a backdrop of high and rising US debt, we believe there is quite a high probability that the US Treasury market could see a sharp market correction within the next five years, regardless of who wins the upcoming US presidential election.
Recent data suggests the US jobs market may be softening, while other US economic warning signs include recent rises in credit card and auto loan defaults, as well as small business bankruptcies.
While it may have become taboo in some quarters to utter the ‘R’ word, some economic signals suggest the likelihood of a US recession is, in fact, increasing. Ironically, we note these latest warning signs are building just as wider talk around recession appears to have evaporated.
Our view is that the evolving economic backdrop will require some deft handling by the US Federal Reserve in terms of its interest-rate maneuvers.
Rising Yields
Despite this uncertain backdrop, higher yields do create opportunities for fixed-income investors who can time their market interventions correctly and take advantage of wider dislocations and pockets of opportunity. We believe fixed-income markets can still throw up alpha, and that we are currently in a market cycle that is conducive to generating income from bond investments. Yield matters, and there is considerable demand from sectors of the market, such as pension funds and retirees, for the higher yields that fixed income can now deliver. In our view, it is possible to construct a diversified bond portfolio that provides yields similar to those available from credit, while being more resilient.
Unconstrained Approach
We believe that over the next few months, fixed-income opportunities appear compelling, even if the medium-term picture is less clear. In our view, the uncertain market conditions call for an active and unconstrained approach to fixed income, along with dynamic decision making, careful market navigation and strong security selection. Despite some continuing macroeconomic challenges, we believe there is significant value to be found across bond markets at this time.
Authors
Ella Hoxha
Head of Fixed Income
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