Unconstrained fixed income views: October 2024
Positive central bank and government policies are helping to alleviate fears of a global economic downturn, and the risks around a soft landing are now more evenly balanced.
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Over the past month we have seen a series of data and policy announcements from central banks and governments, which together imply that the chance of a global hard landing has diminished. Arguably one of the largest downside risks for the global economy in recent quarters has been weakness in China, so the announcements from policymakers that they are determined to arrest the slowdown in their domestic economy, has global ramifications.
In the same way that investors can use put options to insure themselves against market losses, the Chinese authorities are providing a metaphorical ‘policy put’ to protect the global economy from a China-driven slowdown.
Although the details of the stimulus are yet to fully emerge, we believe there is a clear intent to stabilise the economy, bringing down global hard-landing risks and creating some additional scope for a no-landing scenario—if commodity prices find support.
At the same time the US Federal Reserve (Fed), as the world’s most important central bank, contributed to the same sentiment by easing policy rates by 50 basis points in September and—through its accompanying rhetoric—emphasising its determination to head off further downside risks to the labour market. With the Fed easing into an economy that continues to grow at a healthy pace, we feel it is appropriate to increase both the soft- and the no-landing probability, with the former remaining our highest conviction scenario. Put simply, the risks around a soft landing are now more evenly balanced.
Hard-landing risks have fallen, with no landing back in scope
Source: Schroders Global Unconstrained Fixed Income team, 14 October 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.
Certainly not firm, but less fragile
The Federal Reserve kicked off its easing cycle with a bang in September, with the decision to cut rates by a full 50 basis points (bps), certainly not widely expected. The key to this decision was, in the words of Chair Powell, that the Fed “do not seek or welcome further cooling in labor market conditions”. Since then, the strong pace of job creation, indicated by early October’s US payrolls release, was a surprise to many and positive revisions over the month show that the labour market backdrop may be less negative than we thought. So there is further comfort that recessionary dynamics have lessened.
This is not to say that the US labour market is in rude health: Job growth has slowed considerably over the past year, consumers remain downbeat in their job prospects, and small businesses are a long way from signalling a robust hiring backdrop. Nevertheless, the uptick in payrolls, the limited increase in unemployment, and the fact that growth remains healthy in the US are likely to limit the slowdown in hiring we have experienced in the last year. All things considered, a proactive Fed and a less fragile labour market means it is prudent to reduce our probability of a hard landing.
We should also take note of the revisions to personal incomes in the US over the month. The consumer savings rate has been looking low compared to the historical trends, but it has now been revised up due to previous underestimates of income growth. The impact is that the US consumer has more of a ‘buffer’ to draw down on if needed, again diminishing the downside risks.
And it isn’t just the US labour market that has beaten economic expectations. Improving indications of economic surprises more broadly, which were at depressed levels only a month ago, seem to have helped US yields track higher. For now (as the chart below shows) the “economic surprise” index appears to have upward momentum and room to rise further.
It's also important to consider that the latest US inflation developments have shown some near-term stalling on the disinflation path. A 0.3% month-on-month gain in core prices was enough to lift the three-month annualised inflation rate from 2.1% to 3.1%, thanks to a combination of stronger core goods prices and a handful of more robust service sector price increases. As we look ahead, we still believe disinflation is likely to continue, but the latest print is a reminder that the journey will not be smooth.
Chinese policymakers introduce a ‘put’ for the economy
We have held the view for some time that China’s economic slowdown has had a negative impact on the global economy, especially with respect to the global manufacturing sector, with Europe bearing the brunt of it. But it appears that the Chinese authorities have decided that enough is enough and are in the process of introducing a fiscal and monetary ‘put’ for the economy, which provides insurance against further downside risks. And the rhetoric so far is encouraging, being more forceful in tone than in previous quarters where stimulus has been relatively limited.
Details from the Ministry of Finance about stimulus levels are not yet particularly clear, but at the time of writing we anticipate the forthcoming announcement of a fiscal package that tackles not just sluggish consumers, but also aims at stabilising the long-struggling real estate sector.
Ultimately, what does this mean for the global economy? If China does follow through on recent announcements and stimulates accordingly, we believe there could be a worldwide benefit as the globe’s second-largest economy starts to stabilise. Positive spillover effects would no doubt be helpful for regional peers, but it is the currently struggling Eurozone economy that would particularly benefit from the lift offered by a resurgent China.
Although we do not foresee a major commodity-intensive growth package being delivered, even arresting the downside momentum of the Chinese economy could be enough to provide some uplift to global commodities, as shown by the improved sentiment that has resulted just from the policy announcements so far. This incrementally skews higher still the probability of a global no landing.
Where are the opportunities?
We retain a mildly positive view on global duration. While the macro backdrop has become less favourable, it’s also true that valuations have improved significantly over the month, as markets now price a less aggressive profile for the Federal Reserve rate path. Regionally speaking, we are most cautious on the US, retaining a preference for Europe, Australia and Canada, where the macro environment is more conducive for duration (although our macro view on Europe has incrementally improved over the month, helped by a more accommodative European Central Bank (ECB) as well as the potential positive impact from China). We continue to hold a marginal underweight to the European periphery given how little room spreads here have for further tightening.
We have also turned more positive on the UK, having seen a significant improvement in valuations (i.e. lower prices) in recent weeks—although the lower mid-October inflation release has mitigated that slightly—and we look towards the government’s upcoming Budget in late October as a potential positive catalyst for gilts.
From an asset allocation standpoint, last month’s favoured market of agency mortgage-backed securities (MBS) continues to hold onto its crown. Pricing has become more attractive over the month, relative to other areas of credit, while we expect relatively contained volatility in duration to support the sector. We also favour quasi-sovereigns which have, on valuation grounds, received a modest upgrade on our scorecard.
Within corporate credit, we retain our preference for European investment-grade (IG) corporates over those in the US, given more attractive levels (particularly in shorter-duration European credit) and incrementally a less negative outlook on the European economy over the month. US IG valuations are close to the tights over the last 10 years, pricing in a near-perfect economic soft landing. From a high yield standpoint, we again have a preference towards Europe vs the US: US valuations are far from attractive and, as in IG, are fully pricing in a soft-landing leaving spreads vulnerable to a number of risks.
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