Unconstrained fixed income views: August 2024
Some key economic data releases over recent days have prompted an update to the balance of probabilities in our scenario framework, as well as generating significant volatility in markets.
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After reviewing the latest economic data, we have updated our probabilities to reflect an increase in the risk of a hard landing, which we now place at 20% (previously 5%). We left our no-landing risk unchanged at 5%. Although we reduced our soft landing probability to 75% (from 90%), it is worth emphasising it firmly remains our baseline scenario at this stage.
Source: Schroders Global Unconstrained Fixed Income team, 12 August 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.
The increase in our hard landing probability reflects two primary drivers. One is the weakening we have seen in leading manufacturing indicators recently, which has been global. Surveys covering the US, eurozone, and China were all softer this month. Manufacturing is a highly cyclical sector, so we put great emphasis on these signals, and such broad-based softening merits an increase in hard landing probabilities.
The second reason is further signs of softening in the US labour market. Weaker-than-expected jobs gains have been accompanied by a rise in initial jobless claims, and a reduction in consumer confidence measures around the labour market. Given the crucial importance of the labour market for both the growth outlook and the Federal Reserve's (Fed) decision making, it is appropriate that greater signs of slowing in the economy are reflected in higher probability of a hard landing.
We have seen signs of market concern and dislocation in recent days, such as major spikes in volatility indices. But our base case remains a soft landing. In our view, the impact on the growth outlook at this stage due to financial and credit conditions tightening is still very limited.
Moreover, with inflation looking much better now, the Fed has greater ability to offset tighter financial conditions by cutting rates more quickly if necessary. All of this explains why, though we have raised our hard landing probability, we have only increased it to 20%, and a soft landing outcome remains our core view.
How does this relate to market pricing?
Of course, relating this to how we believe the market is pricing is crucial in terms of our market outlook. Although we can’t observe directly the probabilities the market is placing on different scenarios, we can estimate them based on our valuation tools.
The US Treasury market repriced extremely rapidly, with two-year bonds falling more than 50 basis points in the week between Monday 29 July and Friday 2 August (although we have seen some retracement since). We don’t disagree that the Fed is now likely to ease more than was previously expected, but we believe the repricing of yields lower has overshot and expect some of this “hard landing premium” to be reversed.
At the time of writing, the market is currently pricing in almost five full 25 basis point rate cuts over the next four Fed meetings, barely a week since Chair Jay Powell suggested 50 basis point cuts in any single meeting was not under consideration at the Fed.
Our estimates suggest this market pricing is consistent with a hard landing probability higher than our 20% level. For this reason, at current market levels we see being underweight duration as an attractive stance, on a tactical basis.
Implications for investors
Given the extent of the repricing, we are moving away from overweight headline duration positions, meaning our preference is to no longer hold an excess of long-term investments. For duration to perform from here, the market would have to become even more pessimistic on growth and start to price even more cuts. That would be quite a stretch, especially given the decent ISM services print in the US on 5 August, which provided confirmation that the economy is not in freefall.
It's worth remembering that recessions almost never happen “in a vacuum”, out of nowhere. There is usually a large external or internal shock which tips the balance (oil shock, banking crisis, pandemic and so on) – and we are not currently in that type of environment.
Investors can also bear in mind that elections are looming large in the US. Both candidates are setting out a pro-growth position with seemingly little concern about the fiscal deficit – and that also reduces the chance of a recession in the medium term.
As ever, we are closely monitoring the market. We will potentially add duration as we see pricing becoming more reasonable. It’s worth noting too that we have seen a repricing of credit spreads, such that shorter-term investment grade credit now looks more attractive. As a result we are beginning to see decent opportunities here to add exposure.
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