By: Global Unconstrained Fixed Income
It seems that ‘patience is a virtue’ when it comes to disinflation and a more accommodative rates environment.
In the past month, we have increased the probability of a ‘soft landing’ to its highest level within the year, due to significantly improved US inflation news. This has reduced the ‘no-landing’ risk. Because of generally positive economic news, we continue to perceive only a very small risk of a ‘hard landing’.
Greater confidence of a soft landing….no landing risks abate (again)
Source: Schroders Global Unconstrained Fixed Income team, 17 June 2024. For illustrative purposes only. “Soft landing” refers to a scenario where economic growth slows and inflation pressures eases; “hard landing” refers to a sharp fall in economic activity and additional rate cuts are deemed necessary; “no landing” refers to a scenario in which inflation remains sticky and interest rates may be required to be kept higher for longer.
“The journey of a thousand miles begins with a single step”
Major central bank meetings have passed without fireworks. The European Central Bank (ECB) kicked off its easing cycle– a move which was well-flagged in advance. However, given the recent stubbornness in eurozone services inflation and the current growth rebound, we anticipate the ECB’s next move to be cautious.
Meanwhile, the US Federal Reserve (Fed) has revised its rate forecasts, now indicating one rate cut for this year, down from two. Despite this, the committee’s ‘modal view’ still suggests two cuts, as projected by eight of its members.
“Slow and steady wins the race”…?
So, what led us to increase our ‘soft landing’ probability even further? To put it simply; signs of easing inflation pressures. While we consider a whole host of economic indicators, few are as important as developments on the US inflation front. After all, low inflation is the ultimate path to a ‘soft landing’ as it provides room for the Fed to loosen policy. May’s US CPI report (CPI measures the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services) showed promising signs, despite the stubborn shelter inflation. The cost of services, not including housing (the so called super-core measure) improved significantly over the month. In fact, compared to last month, the price of services has actually gone down.
“The experience of democracy is like the experience of life itself—always changing…”
With 2024 being a record year for the number of citizens heading to the polls (over two billion), there was always scope for a degree of political instability. Nevertheless, little would have prepared investors for the number of surprises in such short succession across both developed and emerging markets.
France’s fiscal challenges have pushed the country’s government bond valuations into decline, and the unexpected election announcement has exacerbated market stress. We don’t think the sell-off in European assets creates a buying opportunity just yet – the outlook is just too opaque, and we cannot discount the probability of a noticeable change in the French political landscape ahead. Nevertheless, the indiscriminate nature of the sell-off should present opportunities at some point.
“In the middle of difficulty lies opportunity”
Given the assignment of a high probability to a ‘soft landing’, we foresee challenges for global bond markets to rally structurally from their current position. In terms of asset allocation, we still favour covered bonds over other credit sectors like supranationals and agencies. However, unlike US agency mortgage backed securities, we have been reticent to increase our score on improved valuations alone due to ongoing political risk. For corporate credit, we continue to favour European over US investment grade, but remain cautious due to ongoing political risk.
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Originally Posted June 24, 2024 – Unconstrained fixed income views: June 2024
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I don’t see how one can consider future inflation without considering future government spending. As long as the US govt is on a spending spree driving up the debt you can expect: -Inflation: both from devaluation and also from govt purchases competing with private purchases -High rates Stock PE multiples are becoming unreasonably high. The yield curve is still inverted. Banks are still failing. And the PB ratios of the biggest banks in Europe are downright scary. I don’t see anybody with half a brain lining up to buy a 30 year bonds at 2% in that universe.