Bonds in Brief: Making Sense of the Macro — July issue

What are we watching?

• Bond market sell-off: Long-dated sovereign bond yields rose across developed markets in July. Persistent fiscal deficits, elevated debt issuance and uncertainty around the inflation outlook pushed term premia higher, resulting in a broad sell-off in long-end government bonds. This suggests investors are increasingly demanding compensation for fiscal and inflation risks as they scrutinise policymakers' commitment to both price stability and sustainable fiscal paths.
• Geopolitical risks: Financial markets have largely viewed recent tensions in the Middle East as episodic rather than structural, but the risk of broader disruption to global energy supplies remains. With inflation expectations relatively contained and risk assets near elevated valuations, a sustained increase in oil prices could reignite inflation concerns, place additional upward pressure on bond yields and require higher-for-longer monetary policy stances.
• Central bank policy errors: While headline inflation has declined from its post-pandemic peaks, progress towards central bank targets has slowed, raising the risk that policymakers may be underestimating the persistence of price pressures. Labour markets remain relatively tight in many developed economies, wage growth is still elevated and renewed trade frictions, fiscal stimulus and supply-side disruptions could add further inflationary pressure. If central banks fail to tighten sufficiently where needed, inflation could become entrenched above target and force a more aggressive policy response later. Such an outcome would likely keep government bond yields elevated and place upward pressure on term premia.
• Asymmetric risk in AI: AI investment continues at an unprecedented pace, to the extent it is significantly impacting GDP growth and equity market valuations in some countries. The key issue is whether AI adoption ultimately drives productivity gains, revenue growth and sustainable returns on capital. The investment cycle remains healthy, but we continue to monitor whether spending on data centres, semiconductors and related infrastructure is matched by a growing set of commercially successful AI applications. From a fixed income perspective, one recurring concern is that bondholders capture limited upside if AI succeeds but face meaningful downside if investments disappoint. Investors should remain focused on identifying the companies and parts of the value chain most likely to capture durable economic benefits from AI adoption.

Where are the opportunities?

• We continue to believe that total return fixed income strategies unconstrained by benchmarks are best positioned to navigate the later stages of the economic and credit cycle. Central banks’ divergent policy paths are creating dispersion in growth and inflation, further increasing the likelihood of market dislocations. Looking through the heightened geopolitical instability, we believe that structural tailwinds — fiscal stimulus, deregulation and robust AI-driven capital investment — keep the backdrop broadly constructive. However, elevated valuations across most sectors suggest that success will hinge on selectivity and discipline.
• Today’s uncertain market environment underscores what we see as the growing appeal of an allocation to core fixed income, be it aggregate or credit only. We think higher-quality fixed income remains attractive from both an income and capital-protection perspective, providing a combination of carry and significant potential upside in a risk-off environment. In our view, all-in yields remain appealing for investors looking to de-risk or diversify away from domestic government bonds, providing a potentially smoother return profile.
• European investors can seek to embed resilience and enhance income potential through either a bond allocation in local markets or by going global, particularly if they are concerned about the extent of their exposure to the US or USD-denominated assets. Doing so could also potentially provide a yield pick-up, as hedging costs mean USD-denominated investments have lower yields than EUR- or GBP-denominated equivalents.
• We think emerging market debt (EMD) offers potential as both a return driver and a diversifier in fixed income allocations, particularly for European investors. While EMD has historically been more cyclical and volatile than its developed market counterparts, there are reasons to be structurally positive as risks are increasingly originating from developed markets amid disruptive US policy dynamics. Many EM economies also benefit from muted default forecasts, reflecting solid fundamentals across growth, fiscal and external metrics. Despite heightened geopolitical uncertainty, we think select exposure to EMD could still make a positive contribution to a well-diversified portfolio, mainly through carry and USD weakness.
• In our view, high yield remains attractive from an outright yield-to-worst perspective but warrants a cautious approach given market uncertainty and current spread levels. The robust carry may make this a good equity substitute should investors want to de-risk. We advocate an “up-in-quality” issuer bias and careful credit selection but remain cautiously optimistic that this sector can continue to perform well.