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

What are we watching?

• Escalating Middle East tensions: The US and Iran exchanged fire late in August, reversing earlier optimism around a potential diplomatic breakthrough and reinforcing the risk of renewed volatility in energy markets. Despite intermittent signs of diplomatic progress earlier in the month, negotiations surrounding the Strait of Hormuz remain unresolved. While markets initially responded positively to reports of a possible framework for reopening the waterway, discussions later stalled and uncertainty surrounding shipping access, maritime security and sanctions persisted. As the Strait of Hormuz continues to be effectively shut, oil prices remain elevated and reinforce concerns that supply-side pressures could slow progress towards central bank inflation targets.
• US midterm elections: Ahead of the November midterm elections, investors face increasing uncertainty about the future direction of US fiscal, trade, energy and industrial policies. While major shifts in strategic priorities are unlikely whatever the outcome, changes in congressional leadership could influence the timing and magnitude of fiscal initiatives, regulatory policies and budget negotiations. Given already elevated fiscal deficits and ongoing scrutiny of government borrowing needs, any policy developments that increase spending, reduce revenues or contribute to political gridlock could add further pressure to Treasury markets and term premia.
• AI capital-spending boom: The rapid expansion of AI infrastructure increasingly depends on public and private credit markets as capital spending outpaces free-cash-flow generation. Although the largest technology companies generally enter this cycle with strong balance sheets and growing AI-related revenues, heavy investment, repeated issuance and an uncertain monetisation timeline could hit financial flexibility and bond valuations. New issues are already requiring wider concessions in some areas, while concentrated supply, particularly in longer-dated maturities, may cause existing bonds to reprice even without a meaningful deterioration in credit quality. Risks also extend beyond hyperscalers to data centres, utilities, semiconductor producers and other infrastructure providers. If demand falls short of elevated expectations, overinvestment could result in weaker utilisation, rising leverage and greater credit dispersion. AI may prove transformative, but technological success will not necessarily translate into attractive bondholder returns.
• What about EM? Emerging markets continue to benefit from improving fundamentals and, in many cases, appear more attractive than their developed market counterparts on that measure. Therefore, the key risk to watch is not country-specific policy, but a deterioration in the global backdrop, including questions around Fed credibility, heavy borrowing needs, persistent inflation pressures or a failure of AI-related investment to deliver the productivity gains needed to support growth. While EM economies remain relatively resilient and are better positioned than many developed markets, the world's capacity to absorb further shocks is diminishing, increasing the risk of negative spillovers should global financial conditions tighten materially.

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.
• In our view, today’s 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 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.