Jonathon Gregory
Head of UK Fixed Income

Like almost everyone, I have a love-hate relationship with the smartphone. As much as I object to the way the technology tries to co-opt me into becoming a distracted, doom-scrolling zombie, I cannot deny the benefits. For example, easy access to chess apps allows for a quick mental tune-up while passing dead-time in airport lounges or during the daily commute. These apps are a marvel of 21st Century egalitarian globalization, allowing anyone to be matched-up against anyone at anytime, anywhere in the world.

But jumping into the online chess world can be as bruising for the ego as a real-world run-in with the chess hustlers of New York City. On the train ride home while writing this I am pitched against a high-school girl from Mexico City. Her profile ‘likes’ are chess, Alicia Keys and Pan Dulce, apparently. A few minutes in, and me several pieces down, I gaze out of the window and imagine her on the school run; car-pool Karaoke ‘Girl on Fire’ with dad while she TikTok livestreams the 18 move take-down of the Head of Fixed Income, UK (whatever that is).

Bond investors today live in interesting times – but, much like the smartphone, quite whether this is a blessing or a curse, I’m sometimes unsure. Consider:

  • I don’t keep a scorecard but surely it is not often a central bank will revise up its growth forecast (by quite a lot), revise up its expectation for core inflation (by a little), dismiss recent upside surprises to inflation and yet still validate market expectations for a series of rate cuts sometime over the final three-quarters of the year (and an election year too). Yet the US Federal Reserve (Fed) has done just that in the last few days.1
  • A few days earlier the Bank of Japan delivered a rate hike, (much trailed, but still momentous in the sense that this was the first policy hike since 2007) and officially abandoned its yield-curve-control policy which had helped to cap long-term bond yields for several years now.
  • A day later and the Swiss National Bank surprised markets with a rate cut, much sooner than expected. Then, the same day, the Bank of England kept rates on hold despite the economy being in a technical recession (two consecutive quarters of negative growth in late 2023) and inflation recently tracking lower than the Bank’s own projections for the year.
  • The European Central Bank’s next meeting is not until mid-April but, at its last gathering, took the opposite path to the Fed and downgraded its inflation forecast for 2024, kept rates on hold while governing council members mused publicly about differing trajectories for rate cuts this year.2

At face value it all makes for a rather complicated global picture:

  • Weak global growth (ex-US), and especially where inflation undershoots central bank forecasts, argues for long duration and some caution around credit markets.
  • In the US, labor market resilience and a slowdown in the rate of disinflation, all while the Fed still touts rate cuts later this year, simultaneously upgrading growth and inflation forecasts, is probably good for both risk assets and Treasury bonds (a fairly unusual environment in itself). The US also seems to run fairly symmetrical risks around that base case; either a hard landing as the lagged effects of rates hikes really start to bite (bad for risk assets, good for Treasuries) or stubbornly high inflation and some back-tracking on easier policy (ambiguous for risk assets, probably bad for Treasuries).
  • In Japan, the fact that we are now in the first rate hiking cycle for over 15 years should give even the most seasoned investors pause for thought. And we must also weave in the chances of success, or otherwise, for the Chinese authorities as they attempt to revive their economy from the brink of deflation (a complicated story with global implications), while also considering the possible outcome of the US election later this year (a complicated story with global implications).

Fortunately for me I do not have to address these strategy challenges alone (unlike on where my ongoing failure to master the difference between a Sicilian Defence or the Queen’s Gambit Declined accounts for frequent bouts of poor performance).

Our quarterly Fixed Income Investment Forum met recently to consider all the above issues. Joining together our most experienced investors from around the world across rates, credit, high yield and emerging markets, using a tried and tested investment framework, it is a powerful way to process the latest investment cross-currents. (If only I could tap-into that collective brain on the daily commute).

After a lengthy discussion at the March meeting, the main tactical conclusions (i.e., those we expect to play out in coming months) for our global strategies were:

  • Following the move higher in yields over the last few weeks, overweight positions in short-to-medium maturity government bonds (across almost all developed markets) now have good risk reward characteristics. While it is hard to be sure about the exact degree or timing of policy rate cuts to come, the general trajectory of inflation means most central banks will have room to lower rates later in the year. This should be supportive for bonds. Japan is the clear outlier and needs to normalise policy rates at higher levels while the rest of the world is in cutting mode. Short Japanese Government Bonds as a funding source for longs in other markets (particularly Eurozone and the UK) seem to make sense.
  • We remain cautious towards most credit markets for the time being. While yields on short duration government bonds offer some protection, even if the base case does not play out as expected, the same is not universally true of corporate bonds. Corporate bond spreads – i.e., the premium over government bond yields (and both in investment grade and high yield) – are trading at relatively low levels. This will be fine in the US if GDP growth meets consensus expectations of about 2% this year, but will be very skinny protection if the hard-landing/recession scenario unfolds. So risk/reward is not really in favor of credit, but short-duration US high yield and Euro high yield look like the best trades in this field.
  • Based on our forecasts, the external debt (i.e., hard currency) of several emerging market high yield rated sovereign issuers offers a much better expected risk/reward profile than developed market credit. In several countries an improving monetary and fiscal policy framework is driving access to relatively cheap lending from agencies such as the International Monetary Fund and World Bank. Low net issuance and default rates should provide good technical and fundamental support while yields on some high yield sovereign issuers are still at decade highs.

If it wasn’t clear before, it should be now that we are in completely different territory to the period between the Global Financial Crisis and the COVID pandemic. In that era, the most remarkable feature of central bank policymaking and its impact on markets was homogeneity; the same policy solutions, lower and lower rates with ever expanding asset purchases toward the same market outcomes i.e bond yields headed down and risk assets up.

We now live in a much more divergent world; rate hikes here, but cuts there. Inflation forecasts falling here, but going up there. Growth here, recession there. And all these cyclical trends are playing out against the very challenging longer-term structural backdrop that we have referred to before, particularly as relates to the trends for higher government budget deficits and challenging geopolitics. The short-term prospects for fixed income look attractive but, to drive good long-run returns, everyone must stay alive to the growing risks and manage accordingly. Active management across tactical and structural views will remain a hallmark of a sound investment strategy.

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