Clouds on the horizon: how fixed income investors can prepare for a more volatile future

When we last interviewed you, you expected a soft landing. Is that still the case?

Francois Collet: Back in February¹, we said we thought recession would be avoided and the most likely scenario would be a global “soft landing”.

Fast forward to today, and the market has largely caught up to our view. Many of the central bank rate cuts have been priced out given the ongoing economic resiliency, and the outlook appears benign. In fact, according to the latest monthly Bank of America Fund Managers Survey, 73% of fund managers believe there will be no recession, while 64% believe that a soft landing will be achieved. So, it’s certainly become consensus.

We still expect this, but the outlook has shifted somewhat.

What is your outlook now then? Are you still in the soft-landing camp?

FC: Going into H2, we continue to expect a slow and somewhat sluggish global recovery. While Europe had been a bright spot after a difficult year, recent data has not been so cheerful given the ongoing wobbles in China and the political uncertainty plaguing the Euro region.

And the US has shown some signs of weakness which are worth keeping an eye on. Data has weakened somewhat, with the economic surprise index plunging. Banks have slowed lending. And the construction sector, which is more sensitive to rate hikes than other parts of the economy, is stalling.

Additionally, the labour market is finally beginning to normalise which should help ease wage pressures.² Although we think labour markets should be structurally tighter due to demographic changes, the unemployment rate can tick up quickly, and that’s often how recessions materialise almost without warning. For now, though, we think the labour market is fine and fiscal support should keep the US economy humming.

Overall, a slightly slower recovery will keep inflationary pressures at bay and allow central banks to begin their cutting cycle – which the ECB and others have embarked on, despite some setbacks in Australia and elsewhere.

Having said that, we don’t expect major central bank easing outside of a recession, simply because most of the disinflation is behind us and inflation likely won’t return to their 2% targets long-term. It’s more about central banks striking a balance to support the ongoing expansion.

Will markets become less volatile as a result? And should investors embrace traditional fixed income and longer duration?

FC: We expect macro and rate volatility to remain high – even if the economic backdrop remains benign – for several reasons.

The first is politics. We’ve seen recently that political upsets in the European Union and potentially in the French election can have an outsized financial impact given the ever-evolving policies of candidates like Marine Le Pen and Jean-Luc Mélenchon. And we’ll likely have to wrestle with a Donald Trump Presidential run as well, with his policy platform becoming a key investor concern.

It’s possible these candidates would moderate their views if elected and a re-run of Liz Truss’ disastrous spell in the UK, where bond yields spiked and a crisis erupted, is avoided. That’s partly what’s happened in Italy with Georgia Meloni, where investor concerns have been allayed.

But markets hate uncertainty and must handicap these extreme outcomes – “Frexit”, fiscal standoffs, massive trade tariffs etc. Even if these candidates show fiscal restraint, it will take some time for markets to truly trust them. Until there’s more certainty, therefore, politics should inject volatility in markets - something we’ve already seen in emerging markets like Mexico and India.

Second, many countries are on unsustainable fiscal paths anyway, compounding the fallout from any fiscal misadventures. France, for instance, has a debt-to-GDP ratio of around 111%, its highest since 1887 outside of Covid and World Wars. Meanwhile, it’s fiscal deficit, at -5.5%, puts it well offside with the EU’s 3% limit – along with Italy (-7.4%) and Spain (-3.6%) – and sets the stage for a potential showdown with Brussels.³

The US is in a similarly tricky  situation, with debt-to-GDP of 123% and fiscal deficits of over 6%. Future forecasts don’t paint a rosy picture, either. Federal Reserve Chairman recently labelled this “unsustainable”,⁴ and the IMF has even weighed in, warning that the deficits have stoked inflation and pose “significant risks” to the global economy.⁵

Given this, such countries will have to walk a tightrope, especially given high foreign ownership of their public debt (nearly one-third of US Treasuries and over half of French OATs are owned by foreigners).⁶ Any missteps, like that of Liz Truss, could soon be punished severely by so-called “bond vigilantes”, and there are already signs that Japan is selling some French OATs.

Fiscal dominance is also likely to mean higher rates over the long term, as investors come to terms with a new paradigm of stronger fiscal driven growth, economic uncertainty, and higher “neutral rates”.

Finally, we can’t overlook geopolitics. Whether an escalation with Russia or in the Middle East, which would pressure supply chains and send oil and inflation ripping higher again, or a renewed US-China trade spat, war and deglobalisation are inflationary. And, as we saw in 2022, if we do get an inflationary spiral, even because of conflict, bonds are unlikely to come to the rescue.

Given this, how should fixed income investors approach H2 and beyond?

FC: We have been saying for some time that we are entering a new paradigm, with political, fiscal, economic and even geopolitical forces putting upward pressure on inflation and increasing market volatility, especially for fixed income.

In such a scenario, traditional 60/40 portfolios are unlikely to be as successful as they have been in the past. We have begun to see this already, with stocks and bonds being positively correlated in recent years. In fact, the great moderation period of 1-2% inflation now seems a historical anomaly, rather than a permanent “new normal”. If you look back centuries, rather than decades, you’ll see interest rates and yields right now are actually quite consistent with history.

What does this mean for investors? It argues in favour of having as much diversification in one’s portfolio as possible and as much flexibility. So, having vehicles that can invest across the duration spectrum and even go short when needed could be beneficial. Similarly, assets and strategies that have as many natural hedges as possible might prove useful.