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

What are we watching?

• US-Iran conflict: As of this writing, a comprehensive deal to open the Strait of Hormuz remains elusive, with Iran threatening full closure. Energy flows are likely to remain politically governed, conditionally open and subject to sudden reversal. For markets, the primary transmission channel is through energy prices and inflation expectations. A credible diplomatic path would likely compress the oil risk premium and support duration, while a breakdown in negotiations could push oil prices higher, reinforce inflation concerns and place upward pressure on bond yields.
• Weakening subprime consumer: Financial stress continues to build among lower-credit-quality US consumers, with late-payment trends remaining elevated. The next quarterly data release will be important, as a lack of improvement could indicate that recent liquidity support, including tax refunds, has not materially improved household balance sheets. Importantly, these trends are not representative of the broader consumer, whose fundamentals remain supported by healthy payment behaviour, lower leverage and elevated wealth levels. Instead, the data reinforces a “K-shaped” backdrop in which weaker borrowers face increasing pressure while higher-credit-quality consumers remain resilient. While this divergence continues to support aggregate consumption, it is driving greater dispersion across credit exposures and increasing the importance of borrower quality in security selection.
• Is credit overheating? A striking feature of the current environment is how well markets have absorbed a significant oil supply shock, with credit spreads now tighter than they were at the end of February, when the conflict started and the Strait of Hormuz was effectively closed. The market’s inflation expectations remain relatively benign, driven by a belief that resolution in the Middle East will lead to a normalisation of energy flows over the coming months. However, the market’s ability to absorb this shock so far may have come from temporary offsets, including drawing down inventories, adjusting demand and rerouting existing supply. Crucially, these do not represent a meaningful increase in underlying oil supply. Even if the Strait reopens immediately, we believe production is unlikely to recover quickly. In fact, we estimate it will take at least four months for production to recover to roughly 80% of its pre-crisis levels. While markets can absorb disruption early on in a supply shock, they have historically tended to react more sharply as global commodity inventories fall — meaning smaller changes in supply or demand can lead to sharper moves in prices and more visible pressure on inflation. We are approaching the point where the energy shock may begin to have a more meaningful impact on markets, and this summer is particularly important. As inventories decline and seasonal demand increases, there is a greater likelihood of a pickup in volatility in both credit and rates markets.

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 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. 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.