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Unconstrained fixed income views: February 2024

Our current view of the market is aptly summarised by the phrase ‘Winter recession fears fade but be wary of potential summer heat’.

19/02/2024
GUFI newsletter hero Feb 24

Authors

Global Unconstrained Fixed Income

Over the past month, the chance of a chilling winter recession has continued to diminish. However, the ongoing robustness of the US economy, surpassing expectations, elevates the risk of a ‘no landing’ outcome. For now, a ‘soft landing’ remains our base case.

For the Global Unconstrained Fixed Income team, who assesses the likelihood of various possible states of the world in the form of scenarios, it seems that the economic green shoots of spring have arrived early this year. Despite potential risks persisting within the regional banking sector, the strength of the US economy in particular has led us to lower the possibility of a ‘hard landing’ and raise the chance of a ‘no landing’. While this does not overturn our ‘soft landing' base case, we have reduced the probabilities attributed to this scenario.

Probability of a no landing goes up – soft and hard landing probabilities reduced.

GUFI barometer February 24

Source: Schroders Global Unconstrained Fixed Income team as at 13 February 2024

For illustrative purposes only. “Soft landing” refers to a scenario where economic growth slows, but to a sustainable rate without experiencing recession; “hard landing” refers to a sharp fall in economic activity; “no landing” refers to a scenario in which inflation remains sticky and central banks may need to adjust their current projection for interest rates.

The ‘Goldilocks’ scenario continues to remain our primary hypothesis, though some complications are starting to surface.

We strive to avoid overanalysing a single month’s data, especially at the start of the year when seasonal adjustments can distort the economic landscape. However, there are signs of growing challenges to the ‘not too hot’ ‘not too cold’ soft landing thesis. These challenges primarily stem from the US labour market, which has picked up recently, with some sectors accelerating notably and supporting household consumption. If the current pace of growth keeps up, there is a risk that labour market conditions may begin to tighten once more.

The last mile of returning inflation to target could be a long one

We have been highlighting for a few months now that the trend of goods disinflation (the decelerating pace of price increases) has largely run its course, placing the responsibility on the service sector to further alleviate price pressures. While the housing sector should still be able to help out on this front, the reinvigorated growth backdrop risks limiting this moderation in price gains in other service-linked sectors of the inflation basket.

The idea that reining in inflation to target levels will be a gradual process, and the fact that central banks will need more substantial evidence of progress, has been consistently relayed to investors in recent weeks. The general message to investors is simply don’t get too excited about near term easing of monetary policy conditions.

The recession that never arrived…

An easing of financial conditions has turned more supportive for the growth outlook over the last six months (easing financial conditions refers to a combination of factors, including interest rates and credit spreads – that make life easier for consumers and businesses). To some extent we have started to see this play out in an improvement in the manufacturing side of the global economy.

Nonetheless, we cannot rule out a recession completely. The woes over New York Community Bank and the broader regional banking sector serve as a reminder than tightening cycles can inflict unintended consequences long after the central bank has reached its terminal rate. However, for now, we are comfortable in downgrading the probability of a hard landing.

What does this all mean for portfolio positioning?

We have further tweaked our marginally positive stance on duration over the past month. For now, we find yield curve steepeners (that’s being positioned for longer dated bonds to underperform shorter maturities) more appealing than outright duration.

In terms of asset allocation, we continue to favour high quality credit, including securitised credit, covered bonds and agency mortgage-backed securities. These sectors offer attractive valuations compared to many corporate spread sectors. Within investment grade (IG) credit the US market is particularly unattractive on a valuation basis and we prefer European IG, where some value still exists. Generally, we have a bearish view on high yield.

In currency space, we have turned more positive on the outlook for the US dollar. The recovery in global manufacturing, which has yet to confidently materialise, may eventually weigh against the dollar. However, for now US yields are the primary influence on the dollar’s direction. Rising US yields are likely to be dollar supportive.

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Authors

Global Unconstrained Fixed Income

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