Unconstrained fixed income views: May 2024

The Global Unconstrained Fixed Income team assesses the current macroeconomic environment, and where it might be heading by looking at the likelihood of various possible states of the world. We then consider what this means for fixed income investors.

Alone, together?

At the moment, major central banks are gearing up for imminent rate cuts – the European Central Bank (ECB) will almost certainly cut in June and the Bank of England is likely to follow suit. However, despite their protestations, it’s hard to see how the rate paths of non-US central banks won’t be influenced by the action, or lack thereof, of the Federal Reserve (Fed) in upcoming months given its impact on financial conditions (that’s how cheap / easy it is for consumers and businesses to access finance) commodity prices and currency movements amongst others.

What we really need to see is the softening growth momentum in the US to continue. This would pave the way for the Fed to begin lowering policy rates later in the year.

Greater confidence of a soft landing…. no landing risks abate

Source: Schroders Global Unconstrained Fixed Income team, 21 May 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.

Over the past month, we’ve dialled back the risk of a ‘no landing’, increasing the probability of ‘soft landing’ (our base case) in reflection of early signs of moderation in the US economy and better news on inflation.

This moderation has been pretty broad based across economic indicators, with consumer confidence, the quits rate and initial jobless claims suggesting some of the concerns over the labour market overheating may have been previously overstated. Above all, it is nonfarm payrolls that sets the tone, and the lower pace of hiring in ‘core’ areas (private sector excluding healthcare) was a welcome sign in the latest report. At nearly 100,000 ‘core’ jobs growth though, and 175,000 total payroll gains, the labour market still remains healthy.

On inflation, oil prices have retreated from their April highs as geopolitical tensions abated. Meanwhile, the US Consumer Price Index (CPI) data for April showed further improvement from March, especially in core areas, such as services excluding housing. With core inflation rising almost 0.3% month-on-month, the absolute level remains too high for both the Fed and the market, but the improvement from the first quarter is an important step in the right direction.

Should this softening of growth momentum continue, it will pave the way for the Fed to begin lowering policy rates later in the year.

Hard to explain

There has been one puzzling phenomenon. The last reading from the ISM Services survey was poor, falling below 50 (marking a contraction) for the first time in over a year, with weakness across new orders, employment and production. For reasons that are not immediately obvious though, this previously powerful leading indicator has become less reliable in the post-Covid era.

It is too early to raise the risk of a hard landing on the basis of one very weak survey indicator. However, our scrutiny of services sector data, both official and survey based, will be even greater than normal in upcoming months.

What does this mean for our asset class views?

Our outlook for global bond markets has improved with our reduced probability of no landing, the scenario in which bond returns are most adversely affected. Moreover, the latest Fed meeting quashed the growing discussion of whether further hikes were a possibility if data remained strong – a crucial development. This all justifies an incrementally more positive stance on global duration (or interest rate risk).

Our asset allocation is relatively little changed since last month, with a slight upgrade to emerging market local currency debt the only notable change. We remain positively disposed towards covered bonds (debt comprised of loans that are backed by separate collateral), agency mortgage-backed securities (MBS), shorter dated European investment grade credit and quasi-sovereign issuers, and underweight US investment grade and high yield globally due to unattractive valuations. (Investment grade bonds are the highest quality bonds as determined by a credit rating agency; high yield bonds are more speculative, with a credit rating below investment grade).

—

Originally Posted May 20, 2024 – Unconstrained fixed income views: May 2024

The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.