- Investment Director
Portugal, Intermediary
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Welcome May’s edition of Bonds in Brief, our monthly assessment of risks and opportunities within bond markets for fixed income investors. Each month, we explore material macro changes and how best to navigate the latest risks and opportunities we see within bond markets.
Key points
- Ongoing uncertainty over the implications of US economic policy for growth, inflation and deficits across the globe amplified market volatility, with government bond yields rising in early May on renewed concerns about deficits and tariffs but subsequently declining on positive developments.
- Moody's downgraded its rating on US sovereign debt to Aa1 from Aaa and changed its outlook to stable from negative amid rising debt levels and fiscal deficits. While we still view US government bonds as high-quality investments, the downgrade reflects significantly higher US government debt and interest-payment ratios compared to similarly rated sovereigns. The downgrade may further cement the view that alternative assets, such as European, Australian and Japanese government debt (as well as select currencies), are viable options for investors seeking refuge or diversification.
- The EU gave preliminary approval for a Security Action for Europe (SAFE) lending facility to provide up to €150 billion for member states to invest in defence and security. While much smaller than the €1 trillion+ committed by Germany, it should be a marginal positive for the European economy and a catalyst for further integration.
- As expected, several central banks, including the European Central Bank, Bank of England (BOE) and Reserve Bank of Australia, cut interest rates, while the US Federal Reserve and Bank of Japan kept rates unchanged. Many inflation readings have troughed above 2% targets and are trending upwards. In this context, markets have already taken out a Fed cut for the rest of the year. Similarly, the BOE’s implied policy rate for the end of 2025 was 3.5% at the start of May but rose to 3.82% by month-end.
What are we watching?
- Russia-Ukraine war. Tensions between Russia and Ukraine escalated despite President Trump’s efforts to broker a peace deal. Russia increased drone attacks across Ukraine, but the US has thus far resisted imposing additional sanctions to avoid derailing negotiations on a ceasefire. The conflict is another source of uncertainty, and a resolution or any further escalation could either help or hinder growth prospects in Europe.
- Stagflation risks rising. The minutes of May’s Federal Open Market Committee meeting revealed increasing concerns about the impact of tariff policies on US growth and inflation but highlighted that the “committee was well positioned to wait for more clarity on the outlooks for inflation and economic activity”, indicating that the Fed is likely on hold for now. The deterioration of the growth-inflation trade-off is an increasingly difficult challenge for policymakers across the world. Reduced economic integration and more activist fiscal measures are likely to continue to put upward pressure on long-term rates, cause more volatility in growth and inflation, and increase dispersion between and within markets.
- From trade war to capital war: The US administration and Congress are moving closer to taxing foreign portfolio investments, as indicated by the America First Policy Memo and recent changes in the “Big Beautiful Bill”. Proposed Section 899 of the US Internal Revenue Code, entitled “Enforcement of Remedies Against Unfair Foreign Taxes”, is a retaliatory measure targeting foreign countries that impose taxes the US deems discriminatory or extraterritorial. Although it can be altered in the Senate, significant changes are unlikely. The legislation aims to raise around US$100 billion over the next 10 years and address "unfair" foreign taxes, but its vague nature leaves room for Treasury discretion. This ambiguity could easily alarm non-US investors; it could disincentivise portfolio flows into the US, increase the probability of US Treasury underperformance, erode US exceptionalism and weaken the US dollar by encouraging repatriation of foreign portfolio holdings. The US dollar continued its slide in the second half of May, after a short-lived rally at the start of the month.
Where are the opportunities?
- The risks of a recession have increased yet tariffs are also likely to add to the current inflationary impulse. Given these dual risks, our key conviction remains a focus on higher-quality total return strategies that are less constrained by benchmarks. This could include global sovereign and currency strategies that have the potential to shine during these periods or unconstrained strategies that are able to navigate the late cycle by allocating across different sectors. These strategies could also enable investors to allocate capital away from cash and reduce reinvestment risk without taking on significant duration or credit risk.
- In an increasingly volatile and uncertain market environment, we see core fixed income, whether aggregate or credit strategies, as increasingly attractive from both an income and capital protection perspective. All-in yields remain attractive for investors looking to de-risk within a broadly diversified portfolio. And for European investors looking to protect themselves from ongoing volatility, high-quality income may offer an attractive avenue not just in local but also global markets.
- We think high-yield debt still offers potential, but advocate a cautious approach given market uncertainty and current spread levels. At the same time, the robust additional income potential may make high yield a good equity substitute. For all higher-yielding credit, we believe an “up-in-quality” issuer bias and careful security selection is warranted.
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