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

What are we watching?

• Geopolitical developments tied to the US-Iran conflict have reinforced the risk of a sustained energy‑driven inflation shock. Elevated oil and gas prices increase the likelihood that headline inflation will remain higher for longer and raise the risk of second‑round effects flowing through transport, goods and services costs. In this environment, central banks — particularly the US Federal Reserve (Fed) — are likely to prioritise inflation credibility over near‑term growth support, even as real activity moderates, especially if growing stagflation risks were to materialise. For markets, this dynamic argues for continued volatility in rates, upward pressure on term premia and a more cautious approach to risk‑taking across rates and credit assets until there is clearer evidence that energy prices and inflation expectations are stabilising.
• Central bank decisions will be important drivers of the global cycle in the coming quarters, as policymakers seek to understand and respond to this latest exogenous shock. During March, global central banks opted to keep policy rates unchanged, citing heightened geopolitical risks and uncertainty around the inflation outlook driven by energy prices. Both the Fed and the European Central Bank kept rates unchanged, with an emphasis on being data-led, while the UK saw a dramatic repricing of rate expectations on the back of a unanimous hold vote and subsequent statement by the Bank of England’s Monetary Policy Committee. This latest shock is likely to complicate the task for a central bank struggling to assert its credibility to global investors, as it has overseen the largest cumulative overshoot of inflation in developed markets since the global financial crisis of 2007.
• Private credit woes continue, with increasing concerns around redemption activity and gating of investors in business development companies and evergreen funds, particularly semi-liquid solutions sold in the wealth and retail channels globally. The standard 5% redemption gates are designed to manage liquidity and avoid forced selling for managers, and while most funds (with some notable exceptions) are able to honour redemption requests, the increased demand for liquidity is persisting from a now-broader client base. These dynamics remain a headwind for this part of the market, even as they create an attractive entry point for discerning investors over time.
• Public debt is increasingly an area of focus, as the past 15 years have been characterised by policymakers cushioning consumers and businesses from shocks through increased deficits and ballooning government debt balances. Public debt can shift who bears the cost of a shock, but it cannot remove the shock itself. Accommodative fiscal policies deployed to shield nominal growth convert an economic shock into a monetary one — and ultimately raise the cost of restoring price stability.

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 the growing potential appeal of an allocation to core fixed income, be it aggregate or credit only. In our opinion, higher-quality fixed income continues to be attractive from both an income and capital-protection perspective, providing a combination of carry and significant potential upside in a risk-off environment. 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 provide a yield pick-up, as hedging costs mean USD-denominated investments have lower yields than EUR- or GBP-denominated equivalents.
• In our view, 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 thanks to 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.