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Unconstrained fixed income views: April 2024

Has summer heat arrived early for US inflation? With global growth on a surer footing, we ask whether the recent flurry of US inflation surprises is proving to be a ‘game changer’ or ‘a bump in the road’.

17/04/2024
GUFI outlook April 2024 pic

Authors

Global Unconstrained Fixed Income

The Global Unconstrained Fixed Income team assesses the current macroeconomic environment, and where it might be heading by looking at the likelihood of various possible states of the world.

Our base case anticipates a soft landing. However, we recognize increased risks of a 'no landing' scenario due to a series of US inflation surprises and a potential upturn in the global manufacturing cycle, which could bolster commodity prices. This situation might compel central banks to maintain higher interest rates for an extended period to combat persistent inflation.

Probability of ‘no landing’ rises as robust growth increases inflation risks.

GUFI outlook barometer April 2024

Source: Schroders Global Unconstrained Fixed Income team, 15 April 2024. For illustrative purposes only. "Soft landing" refers to a scenario where economic growth slows and inflation pressures eases; “hard landing” refers to a sharp fall in economic activity and additional rate cuts are deemed necessary; “no landing” refers to a scenario in which inflation remains sticky and interest rates may be required to be kept higher for longer.

US inflation surprises - a game changer or a bump in the road?

In short, we see the latest news of robust US inflation as somewhere in between the two. A string of upside beats does not rule out rate cuts later this year, but it certainly will create reason for the US Federal Reserve (Fed) to pause for thought, with a cut in June now looking like a relatively unlikely probability.

Looking at Fed Chair Jerome Powell’s preferred measure for inflation (that’s core services excluding shelter) the trend in the previous couple of months has been a little concerning. Having risen 0.7% month-on-month in the latest release, this “super core” measure of inflation is now running above 8% on three-month annualised basis. Looking at a broad range of measures, the reality is that inflation is currently running too hot for the Fed to feel comfortable easing monetary policy conditions in the near term.

But it’s not all bad news on the inflation front in the US. As fixed income investors we believe there are more reasons for optimism when looking at the labour market. On several measures the labour market looks like it is returning to balance with wage growth trending lower, vacancies declining gradually and - most importantly - the rate at which workers are quitting their jobs continues to move down. Quit rates are a leading indicator for wage growth, with a declining rate limiting how fast wages rise, as companies are less pressured to keep and attract workers.

The global cycle improves, pointing to a soft landing but with some inflation risk…

There has been continued improvement in global manufacturing over the month. News out of China has been particularly positive lately, something which is likely to disproportionately benefit eurozone growth in the months ahead. While all of this is encouraging for a ‘soft landing’ outcome, we stay alert to the potential that rising commodity prices feed into inflation pressures going forward as this would further challenge the thesis of rate cuts this year.

So what does this all mean for our asset class views?

Although valuations have become more compelling (cheaper), the macroeconomic narrative does justify a move higher in yields and a more cautious Fed. With this in mind, we’re neutral on duration (or interest rate risk) but keep a positive steepening bias on the curve (positioned for the shorter end of the yield curve to outperform the long end). In terms of cross-market, we favour the UK, where we see the ability for the inflation to ‘catch down’ to peers, and the US against the likes of Germany and Canada.

Over the month we have become more positive on breakeven inflation used to capture the outperformance of real yields – which are adjusted for inflation – over nominal yields. We think that upside risk to commodity prices, and some degree of easing by central banks, provide tailwinds to higher breakeven inflation rates.

In credit, we moderate our constructive outlook for European investment grade (IG) based on (expensive) valuations and limited scope for further outperformance. We retain a preference for shorter maturities, where we continue to see value. With US IG spreads close to their tightest levels ever, leaving less potential reward for the risk of investing in corporate bonds compared to safer government bonds, we keep a negative view overall.

Authors

Global Unconstrained Fixed Income

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