Unconstrained fixed income views: September 2024
We see increased risk of a hard landing and the Fed's 50bps rate cut suggests they share this view.
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We’ve raised the risk of a hard landing again, but a soft landing is still most likely outcome
Source: Schroders Global Unconstrained Fixed Income team, 17 September 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.
Falling leaves and rising risks
As the northern hemisphere summer gives way to autumn, the drivers of a rise in hard-landing risks remain. First, the renewed deterioration in the global manufacturing cycle and, second, increasing signs of fragility within the US labour market.
We wrote last month on our growing concerns about the global manufacturing sector. Since then things have got no better, with leading indicators such as the new orders components of the ISM manufacturing survey, the Eurozone PMI and the Caixin Chinese PMI all falling further from already weak levels.
In Europe the automotive sector has weakened as both cyclical and structural forces combine, and the outlook remains a concern for such a macroeconomically significant industry.
Meanwhile, although in the here-and-now the US labour market remains fairly strong, risks of a disorderly worsening have increased. The breadth of job growth across sectors has narrowed to levels which are concerning, job openings in the private sector have fallen substantially, and consumer confidence in the labour market has weakened.
In absolute terms, none of these indicators are disastrous at current levels, and we take heart from the fact that while job growth is slowing, actual job losses (as per initial jobless claims, or permanent layoffs) remain low. But the labour market is non-linear, and waiting for actual weakness to appear before acting is likely to mean being too late. The softening we see across various metrics has already raised the risk that we are near a tipping point from which a labour market recession is unavoidable. We don’t believe we’re there yet, but we’re nearer than we were, and we’d rather not move closer still.
At Jackson Hole a few weeks back, Fed Chair Jerome Powell clearly had some sympathy with this line of reasoning, as he acknowledged the growing downside risks to the labour market, and the policy space available to reduce these risks. He stated in his speech on the economic outlook at the end of August that:“The current level of our policy rate gives us ample room to respond to any risks we may face, including the risk of unwelcome further weakening in labor market conditions.”
In other words: current levels are fine; further weakness is not. The Fed has backed these words with the appropriate action in their latest meeting. But the market's assessment that the Fed will react strongly to further bad news, while responding less to any more positive developments, means there is a natural tailwind for bonds over the medium term.
European struggles
Our higher probability of a hard landing has also been driven by a gloomier assessment of the outlook in Europe, especially in the crucial automotive sector. The manufacturing sector is particularly important for Europe, and any global slowdown therefore particularly impactful. Moreover, idiosyncratic issues surrounding structural changes in demand and competitiveness linger in the background, making cyclical problems worse.
The service sector is faring better but is simply not vibrant enough to withstand the headwind coming from goods. As an example, even Spain—which has been the beacon of positivity in the eurozone economy over the past twelve months—is beginning to show signs of cooling in services, while the first signs of softening in the labour market are also appearing.
Where are the opportunities?
Despite a significant rally over the past month, we remain positive on the outlook for bonds, due to an increased hard-landing probability, growing macro risks and the asymmetric way that central banks are likely to respond to data releases. Despite entry points for long-term bond investments becoming less attractive, we still aim to make the most of market slumps by increasing the maturity of our bond investments when we can.
Given our growing concerns over the eurozone economy, duration in Europe has become a favoured long. The ECB has begun its easing process but has remained cautious so far, with easing coming at only a quarterly pace and forward guidance being extremely limited. We believe that if the macro trajectory continues to soften, the scope for them to turn more dovish and ease more quickly is significant.
We also feel optimistic that in the current market conditions, the difference between the interest rates on long-term and short-term bonds could increase; while this is mostly a global trend, Canada currently seems a particularly apt place to express this given the weak macroeconomic outlook and dovish central bank bias.
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