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

What are we watching?

• US-Iran war escalation. Heightened military activity involving the US, Israel and Iran has increased the risk of escalation in the Middle East, with notable consequences for commodity prices. One-month and six-month oil futures had been climbing ahead of the midterms, with markets immediately expecting lower oil prices as a result of the Democratic sweep; however, volatility is expected to remain elevated. Recent assessments point to possible renewed US strikes on Iran, alongside a meaningful risk of preemptive Iranian action against US interests in the region. A direct confrontation could trigger cyberattacks, terrorism, aviation disruptions, additional sanctions and heightened energy market volatility.
• Growth remains strong, but cracks emerge. In the US, the economy expanded at a robust 3.4% annualised pace, supported by strong consumer spending and investment. Leading indicators suggest growth could remain above trend into early 2027, although tighter financial conditions and fading fiscal support should gradually weigh on activity. Continued resilience could nevertheless keep inflationary pressures elevated and complicate the Fed’s path back towards target. In the euro area, growth also surprised to the upside, largely boosted by Ireland, while activity slowed elsewhere. Going forward, weaker real incomes are likely to weigh on consumption across the region.
• Growing regulatory risks to AI capex. The rapid expansion of AI and data centre investment is likely to face greater US political and regulatory scrutiny following Democratic gains. Several elected Democrats have proposed tighter restrictions on new data centres, including temporary pauses, stricter environmental and permitting requirements, and limits on tax incentives, alongside consumer protections against rising power and infrastructure costs. These pressures could become more significant as AI and data centres become a more prominent issue ahead of the 2028 presidential election, potentially encouraging companies to consider operating in more supportive markets.

Where are the opportunities?

• We continue to believe that total return fixed income strategies unconstrained by benchmarks are best positioned to navigate a backdrop of persistent inflation, tightening monetary policy and elevated market volatility. As central banks increasingly prioritise inflation risks over growth concerns, the potential for policy surprises and market dislocations is rising. While structural tailwinds — including fiscal support, deregulation and AI-driven capital investment — remain constructive for growth, elevated valuations across many fixed income sectors leave little room for error. In this environment, flexibility, active duration management and disciplined security selection will be critical drivers of returns.
• In our view, today’s increasingly volatile and uncertain market environment underscores 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. We continue to view all-in yields as 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, particularly denominated in local currencies, 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 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.