Unconstrained fixed income views: January 2025
The election of Donald Trump has raised the likelihood of inflation remaining sticky and interest rates kept higher for longer.
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Recent economic news has supported the view that the unleashing of animal spirits in the US, thanks to the election of Donald Trump as US President, has pushed up the likelihood of a no landing scenario, where inflation remains sticky and interest rates may be required to be kept higher for longer. In our framework, we’ve moved it to a 35% probability.
This is at the expense of the hard landing scenario, in which we would see a sharp fall in economic activity and additional rate cuts would be deemed necessary, which now has just a 5% probability. There are very few reasons to be concerned about the US economic outlook in the near term, and while the scenarios are global in nature, it’s also the case that the current strength of the dynamics in the US means the region has an outsize impact on the probabilities.
Our scenario probabilities now assign a significant probability of no landing
Source: Schroders Global Unconstrained Fixed Income team, January 2025. For illustrative purposes only. "Soft landing" refers to a scenario where economic growth slows and inflation pressures ease; “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.
Unleashed animal spirits underpin US economic resilience
Post-election, it looked like US corporates were likely to take a favourable view of the incoming administration and, consequently, that economic data would probably remain robust. There were early signs of this last month, but as we move into 2025 we continue to accumulate evidence to confirm this stance. Most notably, small business confidence has risen further, manufacturing sentiment is still firming up, and the latest tick higher in US job openings is a hint that corporate America is becoming more emboldened by the medium-term outlook.
But are things getting a little too hot?
With growth remaining healthy and confidence in the outlook still improving, there are also signs that the economic backdrop may be becoming a little too robust. On the labour market side, hiring plans have improved and payrolls growth has picked up for now, while the unemployment rate has tentatively changed course, moving down in December. This latter point is a crucial one for the Federal Reserve (Fed), which forecast a slight increase in unemployment in 2025.
At this stage it doesn’t warrant an abrupt reaction from the Fed, especially as wage pressures look to be still easing and price pressures are, for now, still relatively contained. However, there’s reason to remain vigilant and the upgrade in the no landing scenario probability reflects these risks.
Adding to the view that the US economy should remain upbeat over the next few months is the observation that, since Covid, the first quarter of the year has tended to see some residual seasonal strength in economic data. Consequently, and even though there have been positive revisions already, there is a greater risk that the consensus expectations for US growth in 2025 may need to be revised upwards.
From reflation to stagflation elsewhere
While the US economy is firing on all cylinders, this is emphatically not the case for the euro area, or for the UK. Here, the post-Budget response from UK corporates has been stagflationary, in that they have both raised prices and cut employment and orders. The rise in employer national insurance tax will translate into higher prices for consumers in 2025, and lead to a more subdued growth backdrop, as employers look to lay off workers to help protect margins.
With UK growth grinding to a halt in the final quarter of 2024, and the near-term outlook looking equally restrained, the Bank of England’s (BoE) bias to ease policy looks justified. However, the continued stickiness of prices means there’s a question mark on how much easing will be possible this year.
The gilt market has seen its fair share of volatility in recent weeks, as the impact of the Budget in October drags on. A combination of limited fiscal headroom together with rising global yields briefly brought into question the practicality of the UK government’s self-imposed fiscal rules, leading to sterling weakness and gilt underperformance. It is a timely reminder that—particularly with an economy facing stagflation—the government does not have full control over how much it can spend.
In mainland Europe, growth appears stagnant overall. However, this does mask stark regional divergences. As Spain continues to out-grow its regional peers, the German economy remains an underperformer with its labour market on the verge of deteriorating relatively swiftly. As a result, there is clearly scope for the European Central Bank (ECB) to ease further towards its neutral level, if not below.
Finally, looking at the “Pacific Divide”, China also continues to find itself in an opposite state to the US. That is, while the US continues to benefit from a respectable pace of growth, with inflation that is a little too hot for comfort, China remains plagued with sluggish growth and an inability to generate much inflation at all. The bond market seems to agree; Chinese 10-year sovereign yields have plunged to new lows in recent weeks, touching 1.6% in early January. To us, this is a clear signal that the economy needs more stimulus to arrest the decline in growth, and subsequently put a floor under disinflationary pressures.
Where are the opportunities?
The upgrading of the no landing scenario probability continues to keep us cautious on outright long duration positions, even if the market has moved sharply in recent weeks towards pricing this scenario more fully. For now, a neutral view remains appropriate, especially given some firming of US growth momentum, payrolls growth, and limited progress on disinflation.
We do, however, retain conviction that curves can steepen further in the coming months, particularly in the US. Although the front end is likely to remain largely pinned to the Fed funds rate, there is an attractive asymmetry should the economy hit a soft patch (which could send short rate expectations lower). At the longer end of the curve, a rising term premium has kept yields under pressure in recent weeks, but we still see scope for this to continue—particularly given the low historical starting point.
In asset allocation, we have made no significant changes to our scoring over the month. The European periphery’s political risk is limited in the near term, but valuations do seem to reflect this in full and hence offer an unattractive risk-reward trade-off.
Our preference for US agency mortgage-backed securities (MBS) is still in place, with valuations attractive and the asset class holding up relatively well despite the move higher in sovereign yields. In corporate credit, we favour the short end of the European investment grade credit curve, where there appears to be more value than elsewhere. More broadly, we continue to believe that high yield (HY) is unattractive at current valuations, but at the margin there is greater value in European HY compared with the US market. As last month, covered bonds remain a relative favourite with valuations currently attractive when compared to investment grade credit and supranational, sovereign and agency bonds (SSAs).
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